By Erin Tenner, Gray Duffy LLP
One of the primary objectives of any transactional attorney aside from getting the deal done for the client –which is a given for an experienced transactional attorney — is avoiding litigation. The potential areas of litigation differ among the three basic types of buy/sell agreements. Those three types are: A Stock Purchase Agreement, an Asset Purchase Agreement, and a Shareholders’ Agreement.
The most frequent areas of litigation with respect to each of these different agreements, and how to prevent them, is discussed below.
The lack of a Shareholders’ Agreement, Operating Agreement, or some other form of ownership agreement is by far the most frequent source of buy/sell litigation. But a poorly-drafted ownership agreement is another common source of litigation. The most common problem areas include dissatisfied parties’ clauses, option clauses that do not clearly state the rights and obligations of each of the parties, and failure to properly plan before exercising a right under one of these provisions. These provisions seem simple, but they can be more complex than those of an Asset Purchase or Stock Purchase Agreement because of the uncertainty surrounding the variety of circumstances covered.
Splitting up is hard to do, which is why having an agreement that is carefully thought out and drafted and signed when all the partners are getting along is ideal. It is much easier to agree when everyone is amicable. If you can’t communicate well enough with your prospective partners to work out an owners’ agreement, you probably should not be partnering.
With no agreement on how to proceed, the parties will typically end up in litigation over who gets what. It is almost impossible to sell a minority interest in a business to a third party, so if a partner wants out and no agreement spells out their right to sell to the other partners, the exiting partner will have to either 1) stay put, and will likely just continue to make everyone miserable until the other partners agree to buy them out just to get rid of them, or 2) sue. Lawsuits can be brought to attempt to dissolve the company, to assert breach of fiduciary duty with respect to minority owners, wrongful termination if they were an employee, or for any other number of claims a disgruntled owner may have.
A better approach is to have a written agreement that says if one partner wants out he or she can notify the others in writing of their desire to part ways. The agreement typically spells out a procedure for setting a price and terms of sale. The procedure can be along the lines of a typical dissatisfied parties’ clause in which one party sets the price and terms and the other decides who is buying and who is selling, or it can give a majority owner or owners the right to buy out the minority owner pursuant to a preset formula or at a preset price and terms.
Option agreements that are part of an owners’ agreements can also create litigation issues. Unclear language in an agreement, such as failure to specify the terms of purchase or how or when the option is to be exercised, are the most frequent sources of litigation. Attorneys who don’t take the time to re-read what they drafted before they send it out can make mistakes that cause ambiguities resulting in litigation. If a client expresses concern about “keeping it simple” — as clients often do — or keeping fees under control, an attorney may sacrifice quality for speed and simplicity. The parties will never realize there is an issue until they attempt to interpret the provisions during a dispute.
Stock Purchase Agreements and Asset Purchase Agreements
Stock Purchase Agreements and Asset Purchase Agreements can also result in litigation, but the most common issues of litigation in these agreements are different than those of a Shareholders’ Agreement.
In Stock Purchase Agreements, litigation typically arises with respect to breach of warranty or indemnity provisions. Keeping warranties and representations clear and simple is the best way to avoid litigation. Often, they are redundant and include unnecessary, inconsistent, and even ill-advised language. For example, financial representations and warranties should never say that financials are true and accurate because this does not allow room for immaterial errors. Rather, a provision that the financials fairly and accurately represent the financial condition of the business protects the buyer while avoiding the right to litigate every little inaccuracy.
Requiring a buyer to do thorough due diligence and providing that nothing discovered during due diligence can be the basis for a lawsuit after closing is another way to reduce potential exposure for a seller. This forces the parties to discuss any issue that is found and resolve it before closing, or the deal will not close. Better not to close than to close and end up in litigation.
Once parties have gone far enough to get to closing, they tend to work out any issues that come up at closing, absent fraud or misrepresentation, because at that point they are invested and highly motivated to get the deal done. Having handled hundreds of buy/sells, I can only recall a few that did not close once they were signed. Even when issues are found in due diligence, the parties tend to work them out with adjustments to the purchase price, holdbacks, or delays while the issues discovered are being addressed.
In Asset Purchase Agreements the issues are different still. Typical issues that result in claims after closing are customer disputes or a disgruntled employee. Since the buyer does not typically buy any of the seller’s liability, these claims are usually much narrower and easier to resolve.
For example, a common area of litigation arises out of employees who are disgruntled about having either been terminated by the seller at closing without being hired by the buyer, or about having been hired by the buyer with fewer benefits and without the seniority they had with the seller. A provision that requires the seller to terminate its employees at closing eliminates the validity of any wrongful termination claim. A provision that the buyer may hire any of seller’s employees it chooses to hire, but is not required to hire any of seller’s employees, absent some misstep by the buyer, will insulate the buyer from most claims by a seller’s employees.
Proper drafting, thorough due diligence, and a solid indemnity provision (and/or holdback or right to offset claims) with a solid seller or guarantor behind it, can protect a buyer from most of these claims. Just as important is making sure you know who you are getting into bed with. Checking out the character of the person you plan to partner with, or buy from or sell to, can be the most important due diligence you do.
Litigation can be avoided with careful planning.