I Gave It All To You, So Why Don't You Like Me: Post-Closing Disputes in Mergers and Acquisitions

May 22, 2013,

As a veteran M & A lawyer in San Jose, where deal making has never gone out of style, I have been though my share of mergers and acquisitions. For business counsel, the closing of a deal is one of the times I get to spike the ball in the end zone as I watch the cash flow to a happy (and relieved) seller. Needing only to put together a closing package, my work is done and I am off to popping the corks at the closing dinner. Or is it?

From sole proprietors and small businesses to large corporations, many business owners enter the sale process believing the closing of a deal is accompanied by a one-way ticket to paradise. They often find out, however, that the fun is just beginning. The first year after closing presents a number of challenges, all of which must be carefully managed to make sure the seller gets the full value of the business.

As I have discussed in prior blogs there are a number of adjustments, associated with audits and working capital, which occur within the first three to six months after closing, including the following:

Post-Closing Audit
The first concerns the post-closing audit. Typically, a selling company's books will close on the actual closing date, and funds will be held back to deal with any adjustments exposed by the audit. Hopefully, the buyer and seller will have agreed in advance to the accounting procedures which must be used, i.e., how generally accepted accounting principles will be interpreted. Otherwise, the first fight will be over whose interpretation should control. This is particularly difficult, because each side may be constrained to using accounting procedures that differ from each other. Key issues in accounting procedures that can lead to disputes revolve around revenue recognition (a favorite for software companies), collectability of receivables, and valuation of hard assets.

Adjustment of Working Capital
The second concerns the working capital adjustment. This follows closely behind the audit, because it is the audit that establishes whether the working capital adjustment established in the acquisition agreement has been satisfied. I have talked before about the working capital adjustment, and like any post-closing adjustment, it is critical to ensure that the parties establish agreed upon accounting procedures to make sure they are not comparing apples to oranges.

Earnouts
The mother of all battles, however, usually occurs around earnouts. I have spoken about earnouts before. Earnout disputes are so pervasive in merger and acquisition deals that litigation attorneys have another word for them: inventory. This is also where the seller must be the most involved. Earnouts depend on business performance, and as much as the seller wants to start their new life, their presence and operation of the company post-closing can make a large difference in the amount ultimately received for their business. Changing business operations, sales approaches, and collection procedures are all matters the former owner needs to watch carefully. One of the biggest issues comes in the form of administrative overhead allocations, with the earnout payment being reduced due to a reduction in net earnings as a result of over allocation of administrative overhead.

Breach of Fiduciary Duty
Another fruitful area for litigation is where a representation or warranty may be breached. We discussed these in past blogs, and noted that, in most deals, funds are held back to satisfy buyer damages arising out of a breach of a representation or warranty. A seller that remains on the shop floor, so to speak, often has the institutional knowledge and relationships to prevent or minimize the acts or omissions that lead to a breach, and thereby reduce the ultimate hit against the holdback that might otherwise occur.

Resolving post-closing disputes is not easy. Most acquisition agreements will require disputes to be resolved through arbitration, which is usually faster than waiting for a court (especially here in California with our impacted court system). Arbitration, however, is not simple, fast or inexpensive. Where post-closing adjustments are involved, many of the issues revolve around accounting concepts, requiring accounting experts to be retained. These experts are not cheap. Where a seller's representation has been breached, complex indemnification provisions are often triggered, which can muddy ultimate resolution. It is not unusual for post-closing disputes to add a year or more to ultimate payout to a seller.

For this reason, sellers should expect that their full payout from the sale of their business may require continued involvement for a year or two after the closing. Sellers may find, however, that the additional involvement is a small price to pay.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Recent California Tax Law Changes

May 13, 2013,

Some tax law changes recently went into effect that that will have an impact on both individuals and businesses in San Jose and throughout the State:

Yet Another Gas Tax Increase
On February 28th the Board of Equalization approved a 3.5 cent gas tax increase, effective July 1, 2013. This brings the gas tax rate to 39.5 cents for 2013-2014. This adjustment should produce revenue at the same rate as if Proposition 30 applied to gas sales. (Proposition 30 resulted in a 0.25% state sales tax increase which does not apply to gas sales.)
Source: Spidell's California Taxletter, Vol. 35.4, April 1, 2013.

Payroll Tax Reporting Changes
The Employment Development Department has announced two changes:

First, employers must use "business days," not "banking days" to determine payroll tax deposit due dates.

Second, an employee is considered a rehire if she returns to work for an employer after a separation of at least 60 consecutive days. Employers must report all new and rehired employees to the New Employee Registry within 20 days of starting work.
Source: Spidell's California Taxletter, Vol. 35.4, April 1, 2013.

For Real Estate Professionals
A real estate professional that spends over half of his or her working hours and at least 750 hours per year materially involved in real estate is exempt from the passive loss rules. These tests are difficult to meet if you also have a job, and the IRS knows it. Since 2007 the IRS has been specifically pulling returns for audit of individuals that claim they are real estate professionals but also have significant W-2 wage income. Be reasonable -- records of time spent on real estate must be contemporaneous and believable.
Source: Kiplinger Tax Letter Vol. 88 No. 8, April 12, 2013.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Lender Liability After the "Riverisland" Ruling - A Time To Assess Lending Procedures?

April 23, 2013,

In the wake of the California Supreme Court's Riverisland ruling concerning lender liability, lenders in the San Francisco Bay Area and Silicon Valley may want to evaluate and consider modifying their current lending procedures. As a San Jose based attorney experienced in loan documentation, problem loans and loan workouts throughout California, I have followed the ebb and flow of lender liability law for many years. Although it is a bit early to assess the long term impact of the California Supreme Court's Riverisland decision, it is not too early to consider precautionary steps, which generally have to be taken at the outset when the loan is being negotiated and documented, to minimize the chance of claims being asserted later.

The court in Riverisland said that a lender's oral statements about loan terms, even if made before the documents were signed, can come into evidence in a lawsuit if the purpose is to show that the lender used fraud to induce the borrower to enter into the transaction. The facts of Riverisland are discussed below. Before Riverisland, if the borrower's evidence of oral statements by the lender about the loan terms was inconsistent with the loan documents, the borrower's evidence could not even come into the case. Now it can, if the purpose is to show fraudulent inducement by the lender. And the facts supporting the borrower's claims can be taken from the borrower's own testimony of his or her recollections. This shifts some bargaining strength toward the disgruntled borrower in problem loan negotiations, as it will be difficult after Riverisland to eliminate such fraud claims early in litigation, or perhaps even before a trial.

The immediate question for lenders is whether any changes in the loan-making and loan documentation process are needed to protect against the potential effect of the Riverisland ruling. Some ideas of possible changes are offered below.

Summary of the Riverisland Case.

A recap of the Riverisland case is helpful. Formally known as Riverisland Cold Storage v. Fresno-Madera Credit Association, 55 C.4th 1169 (2013), this case dealt with a commercial loan secured by California real estate. (The court's ruling, however, applies equally to technology financing, asset based lines, or any other kind of financing facility.) The borrowers fell behind on their payments and the lender and borrowers entered into a restructuring agreement in which the borrowers put up additional real estate collateral for the loan, while the lender promised to forbear and take no enforcement action. The borrowers, however, again missed payments and new loan defaults occurred. At this point, faced with the prospect of enforcement actions and foreclosure, the borrowers paid off the loan.

The borrowers then filed litigation claims against the lender alleging fraud and negligent misrepresentation, stating that two weeks before the restructuring agreement was signed a vice-president of the lender orally promised that the loan extension would be for a period of two years and only two new properties would be required as additional collateral. The actual written forbearance, however, provided for only a three month extension and identified eight parcels of additional collateral. The borrowers signed the forbearance agreement without reading it.

The trial court relied on a 1935 case commonly known as Pendergrass in ruling that the alleged oral statements of the lender could not be introduced into evidence precisely because they varied from the written loan documents. That is, the written loan documents, which contained an integration or merger clause, could not be contradicted by "parol" (oral) evidence that the lender stated the terms of the loan document were something different. In fact, the purported evidence of inconsistent oral statements could not even be considered. This "Pendergrass rule" had stood for over 75 years and has been a useful weapon in eliminating claims that fraud was used to induce a borrower to enter into a loan that actually contained different terms than those the borrower later said it had bargained for.

The California Supreme Court, however, explicitly overturned the Pendergrass rule and held that evidence of purported fraud by the bank could not be kept out. The court nevertheless indicated that the mere fact the evidence of fraud could come in did not mean it would be a winning argument; that is, the borrowers may have been negligent themselves for failing to read the loan documents even if the lender's oral statements were made.

The Potential Problem for Lenders.

The key point from Riverisland is that the evidence of oral discussions to support a fraud claim can no longer simply be kept out of litigation. That opens the door to discovery and evidence gathering, and makes it more likely the matter will go to trial. Given this new reality, the lender should consider if it has established a foundation that makes it as easy as possible to show that the disgruntled borrower's recollection of oral discussions are inaccurate or unreliable, or are put in proper context by other evidence.

Tips for Reducing Potential Claims.

To mitigate the potential negative effects of the Riverisland case, a lender should consider changes in how it conducts loan negotiations, documentation and closings. As always, business judgment will be important in deciding whether a specific change is necessary or makes sense in your particular situation. Some ideas to consider are:

1. During oral discussions with borrowers the lender should qualify statements by noting that all terms must be confirmed by the lender in writing. Be vigilant to follow up any oral discussions about loan terms with email, written summaries and/or term sheets to the borrower. If there is an important provision on which the parties do not agree, put the lender's position in writing, or note the fact that the lender has not agreed to the borrower's request.

2. Provide execution versions of final loan documents well before closing, so the borrower has sufficient time to review them prior to signing. Do not present drafts of written documents for the first time at a meeting to sign documents and close the loan.

3. Include a summary of key terms in an obvious place in the loan documents.

4. Include with the loan documents a statement that the borrower has thoroughly reviewed the loan documents and they are consistent with the agreement of the parties and no other agreements have been made. Alternatives for expanding this: (a) have that section initialed; (b) add a representation that the borrower's counsel also reviewed the loan documents; (c) have the statement made/signed on a separate document; and/or (d) include a representation that the statement is made under penalty of perjury.

5. Increase the use of initials on loan documents, so the borrower explicitly acknowledges its awareness of important provisions.

6. Increase the use of bold or large size font to highlight important sections of the loan documents.

7. The potential for increased litigation makes it more important than ever that a jury trial waiver and alternative non-jury proceedings are specified in loan documents, such as judicial reference or arbitration.

The above points indicate ways of reducing potential claims of fraud, in the wake of Riverisland.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Closing the Deal: Boring is Best

March 27, 2013,

Having represented both buyers and sellers in mergers and acquisition transactions in Silicon Valley for more years than I care to admit, I have been through a number of closings. Some M&A closings that I have been involved in were smooth affairs, accomplished through an exchange of a single phone call with a confirming email, while others have stretched into all night marathons. Although it is often difficult to know whether your deal will allow you to finish at a reasonable time, there are a number of actions you can take to make sure your closing is as smooth and stress free as possible.

Obtain Third Party Consents:
The most important task for both the seller and acquirer is to plan ahead. Everything you will need, to accomplish the closing, will take longer than you think. One item which often delays a closing is getting the necessary consents to the transaction required from third parties. Certain third parties, often parties to major relationships that the acquired company, post-closing, requires for its operations, have rights under their contracts to consent to any change in control. Many of these contracts create significant value for the acquired company and their continued existence are often a key incentive for the buyer proceeding with the deal. It is best to identify these material agreements early on and plan a strategy for securing the necessary consents. Other areas where third party consents might be required are when a party, often a strategic investor, has a right of first refusal that is triggered by the transaction.

Obtain Stockholder Approval:
Stockholder approval, especially where large numbers of stockholders exist, can often be a gating item. As with third party consents, it is critical that the parties design a strategy early on for soliciting approvals from the stockholders, and, if necessary, investigate and resolve any securities compliance issues that might exist. This may require significant advance planning and document creation, particularly for securities compliance purposes.

Complete Agreements and Disclosure Schedules Before Closing:
Part of planning ahead is to front load all of the work that needs to be accomplished for the closing. For those transactions in which a closing follows sometime after the contract signing, agreements and schedules required for the closing, such as key employment agreements and disclosure schedules, should be completed and attached to the contract as part of signing. The temptation to put these types of schedules and agreements off until the closing can prove costly, as these types of documents, particularly a disclosure schedule, can raise issues which may require significant time to resolve.

Remove Contingencies:
As a closing approaches, it is critical to make sure all contingencies pertaining to the closing are removed or waived. One way to ensure this is to make sure, during contract negotiation, that contingencies are based on standards that are objective and easy to determine. One area that can be problematic is a contingency based on the occurrence of a material adverse effect. Because these tend to be very broadly and qualitatively designed, it is best to objectify them as much as possible. This can be accomplished by tying the effect to financial or other measures, or limiting it to known risk issues.

Have a Pre-Closing Review:
Expectations during this period need to be rational. If there is any deal term or contingency that is open, the transaction simply is not ready to close. For this reason, it is always a good idea for the deal team to conduct a pre-closing a few days before the planned closing date, to make sure all remaining issues and contingencies are resolved and that the documentation is sufficiently in order to close.

Be Closely Involved:
The most important task for the business executive is to understand that his or her job at this point in time is not necessarily to run the business, but to get the deal done. The executive needs to be closely involved with the transaction, and should not merely rely on his or her advisors. There is no substitute for carefully reviewing all of the documents involved in the transaction. In addition, the executive needs to ensure that the entire deal team be available for the inevitable last minute decisions.

Like many things in life, closings benefit from advanced planning and hard work early on. Save the surprises for birthdays and holidays. When it comes to closings, boring is best.


The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Do I Really Need to Formally Dissolve My Corporation?

March 20, 2013,

A few years ago, I met with a new client here in San Jose about forming a corporation for his real estate management business. He wanted to use his name as the name of the corporation, e.g. John Smith, Inc., and he had no problems with using his name as the Agent for Service of Process, and having his home address as the business address on public record. Imagine my surprise when I went to the Secretary of State's database to confirm that the name was available and found that the exact name was taken by the same client at the same address. The corporation had been formed back in 1989 and had been suspended for decades.

I discussed it with the client and discovered that he had spoken with another lawyer about forming a corporation many years ago, and although he thought it was just an informational meeting, the attorney actually formed the corporation and the client didn't even know about it. If my client wanted to use the name of the suspended corporation, he would first have to revive it, in which case, he would have had to pay tens of thousands of dollars in back franchise taxes and interest. I counseled the client to walk away from the suspended corporation and simply start a new one under a different name. In this case, that was okay because he took no assets from the corporation and therefore could not be held personally liable for the corporation's taxes. However, shareholders should not walk away from a corporation without carefully considering whether the same conclusion would apply to their situation, and whether they are willing to endure the annoying tax notices to the corporation in the meanwhile.

The landmark case in this area is the Appeal of Howard Zubkoff and Michael Potash, Assumers and/or Transferees of Ralite Lamp Corporation (April 30, 1990, 90-SBE-004). In that case, the Board of Equalization stated that the only way shareholders are liable for the corporation's franchise taxes would be if the Franchise Tax Board proves that all of the following conditions were met:

- The corporation transferred property to the shareholder(s) for less than full and adequate consideration;
- At the time of transfer and when shareholder liability was asserted, the corporation was liable for the taxes;
- The transfer was made after liability for the tax was accrued;
- The corporation was insolvent at the time of the transfer or as a result thereof; and
- The FTB had exhausted all reasonable remedies against the corporation.

Source: Spidell's California Taxletter Vol. 34.11, Nov. 1, 2012

Even if a shareholder thinks he, she, or it qualifies under the Ralite conditions, and would not be held personally liable for the taxes, the shareholder must understand what the last condition means - the FTB may exhaust all remedies against the corporation in trying to get it to pay the taxes. The FTB will send the corporation a Demand to File notice, then a Notice of Proposed Assessment, and then try to collect against the corporation. Since the FTB is pursuing the corporation and not the shareholder (yet), there is no defense that the shareholder can offer. A Ralite defense is inapplicable at this stage because that is a defense by the shareholder, not the corporation. A shareholder needs to be willing to receive these documents on behalf of the corporation and not respond until the FTB eventually comes after him or her personally for payment. That is when Ralite can be invoked. And that is when the taxpayer will have to prove the above conditions are met by providing supportive documentation to the FTB. This could be a long process requiring ample time and attention from the shareholder.

If the corporation was formed back in 1989, and the shareholder clearly meets the above conditions because he wasn't even aware of the formation, walking away makes sense. However, if the corporation just failed to file a final tax return or dissolve with the Secretary of State in the last few years, the shareholder may be better off paying the back taxes and interest to avoid this hassle in the future.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

The Phantom Trustee - Not a Problem on a Deed of Trust

March 11, 2013,

Those of us involved in real estate loans, debt financing, and problem loans or loan workouts have sometimes wondered whether a deed of trust can be valid if no trustee is identified. I am often asked this question and, surprisingly, the issue was never been directly addressed by California courts until the end of 2012! In a decision handed down a few months ago, a California Court of Appeals ruled that the omission of a named trustee on a deed of trust at the time it is executed and recorded does not preclude enforcement of the deed of trust through a foreclosure sale of the secured property.

The facts of the case are straightforward. A real estate loan was made and secured by a deed of trust on the property being purchased. The lender designated Mortgage Electronic Registration Systems, Inc., or MERS, as the beneficiary and simply omitted naming a trustee. Later, the borrowers defaulted on the loan and MERS then recorded a substitution of trustee naming ReconTrust Company, N.A. (ReconTrust) as trustee, and assigned its beneficial interest under the deed of trust to a loan servicer who further assigned the beneficiary's rights to Arch Bay Holdings, LLC - Series 2010B (Arch Bay). As newly appointed trustee, ReconTrust filed the required notice of default and notice of sale, and eventually conducted a trustee's sale at which Arch Bay purchased the property. After the sale, the borrowers filed a lawsuit asserting, among other things, that the failure to designate a trustee in the original deed of trust was a fatal flaw and precluded any trustee's sale under the power of sale in the deed of trust. See, Shuster v. BAC Home Loans Servicing, LP, et al. 211 Cal.App.4th 505 (2012).

The court first noted that this issue had never been addressed in prior California rulings. After wading through some technical arguments, the court ruled in favor of the lender or creditor and against the borrower, stating that the essential validity of the deed of trust is not affected because a trustee is omitted in the original deed of trust, as long as a trustee is named prior to a foreclosure. The court reasoned that the very limited powers granted to a trustee under a deed of trust - to convey the property at an out of court sale - are insufficient incidents of ownership or control to make the actual naming of a trustee critical to the validity of the document.

Caveat: This decision is strictly limited to deeds of trust and does not apply to any other types of trusts.

If you are involved in a real estate loan or other financing, perhaps in Silicon Valley, San Jose or elsewhere in California, we still advise that the deed of trust contain the name of a trustee, as it avoids the risk that other critical information will accidentally be omitted. However, if the trustee name is for any reason not specified, there no longer is any doubt that the lien remains valid and enforceable.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Limited Liability Company Short Form Cancellations

March 4, 2013,

Last November, I was working closely with one of our clients and their real estate lender to purchase a large property in the San Francisco Bay Area. I formed two California limited liability companies for the transaction. One LLC was the investment entity that was going to own the property, and the other was the management entity that was going to hold the sponsor interests in the deal. Both entities had to be properly and fully formed so that we could obtain good standing certificates from the Secretary of State and be in position to issue legal opinions for the lender. During the due diligence period, our client discovered something about the property that was not what had been represented to them by the seller of the property. As a result of this information, the purchase fell through.

Fortunately, despite all of the other costs expended on pursuing this property, the client had not yet paid the $800 franchise taxes for each of the two LLCs we formed. In California, if an LLC meets certain requirements it may cancel its Articles of Organization within 12 months of the filing by filing a Short Form Certificate of Cancellation with the Secretary of State, and avoid paying the first year's franchise taxes. These requirements include:

- The California LLC has no debts or other liabilities (other than tax liability);
- The assets, if any, have been distributed to the persons entitled to them;
- The final tax return has been or will be filed with the Franchise Tax Board;
- The California LLC has not conducted any business since filing the Articles of Organization;
- A majority of managers or members, of if there are no managers or members, then the person who signed the Articles of Organization, voted to dissolve the LLC and
- If the LLC has received any payments from investors for LLC interests, those payments have been returned to the investors.

Source: Spidell's California Taxletter, Vol 34.11, Nov. 1, 2012.

Because our client met all of these requirements, we were able to cancel the LLCs without paying the $1600 ($800 x 2) in California franchise taxes. If, on the other hand, the client had already paid the taxes, we would not have been entitled to a refund. With this in mind, sometimes when forming an LLC it may be better to wait until the last minute before the franchise taxes are due before paying them to make sure the business is going forward, as long as you either pay them before late fees would be imposed, or you are willing to incur late fees in the event your LLC does not qualify for the short form cancellation.

Continue reading "Limited Liability Company Short Form Cancellations" »

2013 Changes to California Laws that Affect San Jose Taxpayers

January 31, 2013,

Although 2013 is well under way, taxpayers in San Jose may not be aware of changes to California laws that may affect them. Some of these changes include:

Proposition 30

With all the talk about federal income taxes going up this year, do not forget about the Proposition 30 retroactive increase in California taxes, effective as of January 1, 2012. For taxpayers with taxable income over $250,000, the California maximum rate is now 12.3%. On top of this, there is a 1% mental health surcharge for taxpayers with taxable income over $1,000,000. Together, these taxes give California the highest maximum state tax rate. If you fall under these tax brackets, you may not have paid enough taxes throughout the year, through either withholding or estimated tax payments, to avoid being under-withheld. However, there will be no penalty for the under-withholding so long as you pay the tax due in full by April 15, 2013. The ability to get out of penalties expires on April 15th. An extension to file doesn't extend the payment deadline or the penalty exclusion. A late payment penalty of 5% plus 0.5% per month will be due if the full 2012 liability is not paid in full by April 15th.

Source: Spidell's California Taxletter Volume 34.12, December 1, 2012.

Sales Taxes

As of January 1, 2013, the California state sales and use tax rate increased by 0.25% to 7.5% for four years. Of course, city and county district taxes are added on top of the 7.5%.

Source: Spidell's California Taxletter Volume 34.12, December 1, 2012.

Retirement Contributions

Taxes may be going up in 2013, but dollar limitations on retirement plans will also be higher this year. The maximum 401k contribution has gone up $500 to $17,500, with people born before 1964 able to put in as much as $23,000. The pay-in limitation for defined contribution plans goes up to $51,000, and the pay-in limits for IRAs and Roth IRAs goes up to $5,500, with an extra $1,000 of pay-ins available to those born before 1964.

Source: The Kiplinger Tax Letter, Vol. 87, No. 22 (Oct. 26, 2012).

IRS Mileage Rate

It is important for businesses to be aware of the current standard mileage rate since many use that rate to figure out both their reimbursement amounts and their tax deduction for miles driven in the course of business operations. The IRS has announced the mileage rates for 2013:

• 56.5 cents for business miles (up from 55.5 cents in 2012)
• 24 cents for medical and moving miles (up from 23 cents in 2012)
• 14 cents for charitable miles

California conforms to these amounts.

Source: Spidell's California Taxletter Volume 34.12, December 1, 2012, p. 143.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Closing Conditions Common in Acquisition Agreements, Part 2

January 22, 2013,

The pace of merger and acquisition activity in Silicon Valley continues unabated, and the satisfaction of conditions to make sure both parties conclude a deal with all loose ends tied up becomes critical to a final closing. In my last blog, I discussed certain standard closing conditions contained in merger and acquisition documentation, particularly the requirement of stockholder approval and the use and impact of dissenters' rights. In this blog, I will cover some of the other commonly used conditions in acquisitions of privately held companies.

Being a technology transfer lawyer, many of my clients' deals focus on the need to retain key employees after the company is sold. For that reason, a key closing condition included in most acquisition agreements requires that certain employees with the acquired company agree to continue working with the company for a period of time after the closing. Often this obligation is structured by requiring the employees to sign employment agreements or consulting agreements with the buyer. Managing this process can be tricky, because employees will want to agree to terms they find preferable (e.g., receiving additional options and higher salary) and some key employees may be reticent to work with a buyer they do not know. In addition, negotiations occur between the key employee and an acquirer before a deal is closed, which is sometimes an awkward process.

Covenants Not to Compete
A corollary to this condition is the buyer's desire to have key employees sign covenants not to compete. Although generally unenforceable in California, these covenants can be enforced where the key employee holds sufficient stock, and has sufficient control, in the acquired company to warrant protection of the buyer's interest after the sale. The covenant must also be for a reasonable time, and limited to a reasonable geographic area. Because of these somewhat vague standards, buyers often want these covenants signed by as many of the key employees/stockholders as they can. Key employees, understandingly, become very apprehensive about signing these documents, because many are not receiving enough money from the deal to be able to afford being shut out of the industry in which they have developed a substantial expertise.

Employee Releases
Where a selling company's shares are closely held, or where a substantial percentage of the shares are held by a small group, a buyer will often want the stockholders to release the company from any claims the stockholders may have. This may present a problem if any selling company stockholder has any claims, or even hard feelings, against the selling company. Requiring them to sign a release provides them great leverage in getting their claims or concerns resolved in their favor.

Material Adverse Impact
Another key closing condition is the absence of any "material adverse impact". It is often defined as an impact to the acquired company that is material and adverse. Helpful, huh? There lies the problem with this condition. Although it behooves parties to objectively define what is both material and adverse, too many times parties want to rely on an "I'll know it when I see it" standard. Using objective standards here is critical, because there is precious little time to use standard dispute resolution proceedings to decide who is right or wrong when you are trying to close a deal.

Regulatory Requirements
Satisfaction of regulatory requirements is another important closing condition. Where publicly-tradable securities are being issued, acceptance of an appropriate registration statement by the SEC is often a condition. For acquired companies with a smaller stockholder group, mature buyers can often get the selling stockholders to agree that shares issued in the acquisition will be registered after the closing. Other regulatory requirements could include bulk sales filings for certain types of deals, and antitrust filings.

Legal Opinions
One of the last closing conditions, which is unfortunately one of the last to be considered, is the infamous legal opinion. This is a letter written by one party's counsel to the other party providing certain legal conclusions, or opinions, about the state of the party and the transaction. Because legal opinions are provided, or rendered, to a non-client, attorneys are very sensitive about their content, and the opinion letter itself is an almost incomprehensible collection of jargon and assumptions. The opinion is also based on factual representations provided by management, and attorneys typically provide, right before the closing, confirmation documents concerning facts on which their opinions are based.

Because every deal is unique, other closing conditions may be present, and some of those discussed above may be absent. In any event, it is important that both attorneys and their clients work toward their completion, so that the closing a business sale can proceed with as little controversy as possible.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Real Estate Loans, Mezzanine Financing and Intercreditor Agreements: Sometimes Words Mean Something

January 16, 2013,

An investor bought an apartment building in San Jose and the broker wanted to send flowers for the occasion. A large bouquet was delivered to the buyer's office with a note that read, "Rest in Peace."

The buyer was irritated and called the florist to complain. After he had told the florist of the obvious mistake and that he was not pleased, the florist said: "Sir, I'm really sorry for the mistake, but what I'm more concerned about is . . . there is a funeral taking place today, and they have flowers with a note saying, "Congratulations on Your New Apartment!"This amusing joke is a good way of reminding us that both real estate and business deals continue to be closed in the Bay Area. As a banking, real estate and business lawyer representing parties to these transactions, I am very aware, and I expect most readers are as well, that financing continues to be a critical part of making a successful deal. During the robust period prior to 2008, one way parties garnered additional leverage in structuring real estate transactions was to utilize so-called mezzanine financing, in which the collateral securing a junior layer of debt consisted of the ownership interests in the borrower rather than the real estate. When the borrower was a limited liability company, this junior loan collateral could be secured through a pledge of the membership interests the owners held in the borrowing LLC.

The concept of using mezzanine debt to enhance leverage has not gone away. However, recent cases looking at transactions structured several years ago have curtailed the latitude of mezzanine lenders ("Mezz Lender") and improved the position of the senior secured lender ("Mortgage Lender") in the event problems arise after loan closings. If you are a Mortgage Lender holding real estate collateral, this may make it more attractive for you to enter into a transaction involving mezzanine financing. If you are a Mezz Lender or a borrower seeking to obtain and use mezzanine financing, obstacles now exist that were not there - or at least not believed to exist - before the markets collapsed in 2008.

The most significant point to take away from the recent case law is the enormous importance of the intercreditor agreement in multi-party transactions. This includes mezzanine financing discussed here, as well as other arrangements involving multiple creditors. In the cases mentioned below, the courts specifically analyzed the language and terms of the intercreditor agreements executed by the parties in reaching their rulings and, therefore, the exact language drafted into the intercreditor agreement will significantly affect the rights of the parties. If you become involved in a financing using mezzanine debt or a transaction with multiple creditors, close attention should be paid to the intercreditor agreement regardless of your position in the transaction.

Now, we discuss some basics about mezzanine financing and then assess the recent case law. Mezzanine financing provides an opportunity to apply an additional layer of secured debt to a real estate transaction by using the equity in the borrower itself, which are held by the owners. This debt is in addition to the Mortgage Lender's loan, which is secured by a first deed of trust against the subject property. For example, assume an entity acquiring real estate is an LLC, and the Mortgage Lender will loan 65% of appraised value based on its underwriting policies. This amount, however, is insufficient to close the transaction. A layer of mezzanine financing might be obtained by having the owners of the LLC, i.e., its members, pledge their interests in the borrowing LLC to secure additional loans. This financing, secured by entirely separate collateral and often provided by an entirely different lender - the Mezz Lender, reduces the owner/investor funds required to complete the purchase.

The Mortgage Lender, holding real property collateral, and the Mezz Lender typically enter into an intercreditor agreement as well, whereby the mezzanine financing is, among other things, subordinated to the loan held by the Mortgage Lender. But other terms and conditions are also rounded up and placed in the intercreditor agreement, including provisions limiting the remedies of the Mezz Lender while the senior secured loan is in default. One common term in many intercreditor agreements requires the Mezz Lender to cure defaults in the senior secured loan prior to transferring its interest in the borrower through a UCC foreclosure sale of its collateral to a "qualified transferee."

In the event problems develop with the project and defaults occur in the senior secured loan, the ultimate remedy for the Mortgage Lender, at some point, is to commence foreclosure proceedings. When this occurs, and particularly if values have declined, the junior Mezz Lender's strategy for protecting its interest frequently involves taking control of the borrower through a foreclosure sale of the ownership interests, and then placing the borrower in bankruptcy to maintain control and buy time to work out a liquidation that, to the extent possible, increases value at sale and protects the Mezz Lender's interests.

Recent court decisions, including Bank of America, N.A. v. PSW NYC LLC, 918 N.Y.S.2d 396, 2010 N.Y Slip O-p. 51848(U) (N.Y. Sup. Ct. Sept. 16, 2010), and U.S. Bank National Association v. RFC CDO 2006-1 Ltd., Case No. 4:11-cv-664, Doc. No. 41 (D.Ariz Dec. 6, 2011), changed the playing field for these strategies by reaching the conclusion that the Mezz Lender is required to cure all defaults, including repaying the entire senior secured loan if that loan has been accelerated or matured, prior to conducting its UCC foreclosure sale. The Mezz Lender also may have to replace guarantors supporting recourse carve outs prior to a foreclosure. The bottom line is that these court decisions, which seem to be generating persuasive force, shift negotiating power in a workout or problem situation to the Mortgage Lender at the expense of the Mezz Lender.

As mentioned, these cases carefully scrutinized the intercreditor agreements, and therefore it will be worthwhile for a party to the transaction to pay close attention to that agreement.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

More Case Law for Employee Non-Compete Agreements

December 21, 2012,

Having practiced corporate law in Silicon Valley for 15 years, I must say that there is nothing more frustrating for my clients, who are mostly closely held businesses in the San Jose area, than spending months or years training an employee only to have her leave and go on to compete with the company that trained her. In particular, I represent several staffing and consulting companies and have had to listen to their complaints of how unfair this is from the employer's perspective. Often, I have to tell these hard working, small business owners that there is almost nothing they can do (except pursue a claim against the employee for misappropriation of trade secrets). In 2008, the California Supreme Court decided Edwards v. Arthur Andersen LLP, making it clear that employee post-employment non-compete agreements are unenforceable in California except in certain very limited circumstances, including in connection with the sale of a good business involving goodwill.

Now, a new California Court of Appeals case, Fillpoint, LLC v. Maas (August 24, 2012) further enforces California's attitude towards fostering open competition and disfavoring restrictions on employees. In the Fillpoint case, a major shareholder and key employee signed both a three year non-compete agreement related to the sale of his stock, and a one year post-employment non-compete in his new employment agreement. The Court paid particular attention to whether the stock purchase agreement and the employment agreement should be read together as one document. The employment agreement alone would violate California's view of post-employment non-compete agreements as against public policy. However, in connection with the sale of the business, it could be enforceable. In this case, the shareholder/employee worked for the acquired company until the three year non-compete ran out, but then terminated his employment and went to work for the competition. The company claimed that the one year non-compete covenant in the employee's employment agreement should restrict him from such competing employment. The employment agreement non-compete provision specifically prohibited him from making sales contacts or actual sales to any customer or potential customer of the company, working for or owning any business that competes with the company, and employing or soliciting for employment any of the company's employees or consultants.

The court found that the two agreements should be considered integrated because the covenants were executed in connection with the sale or disposition of stock in the acquired company. In particular, they noted the integration clause in the documents, which stated that if there were any conflicts between the two documents, the stock purchase agreement would control. The court went on to consider whether the non-compete and non-solicitation covenants should be void and unenforceable, and found that they were because they were overly broad. In particular, the court noted the over-broad restriction against selling to potential customers of the company.

So what does this new case teach us? Non-competes are still extremely limited in California. And for me, as a business attorney in the Silicon Valley where mergers and acquisitions are either a way of life or an exit strategy for most businesses, this case reminds me how careful business lawyers have to be when drafting these provisions to make sure they are enforceable. Non-compete provisions should be clear that they are connected with the purchase and sale of a business, including any specific payment allocated to such non-compete covenant. And when drafting a non-compete, do not try to make it any broader than necessary to protect the goodwill being acquired.

There is another question that comes up often in my practice. After I am done explaining how most non-compete covenants are illegal and unenforceable in California, my small business clients almost always ask about whether they can include an employee non-solicitation agreement instead, to at least prevent the person leaving from taking key people with them. I really wish I could clearly and conclusively tell them that they can, but I am not so sure anymore. In the past, we could point to the Loral Corp. v. Moyes (1985) case which held that employee non-solicits are enforceable in California. However, the Arthur Andersen case and now the Fillpoint case make this position a lot less certain, even though they don't specifically overturn Loral corp.

Where does this leave us? It seems like we say this every year, but it is time to revisit your employment agreements and independent contractor agreements. If you insist on keeping an employee non-solicitation covenant, make sure it is as narrow as possible and that your agreement has a severability clause to (hopefully) save the rest of the document in the event a court finds the restrictive covenant to be void and unenforceable.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

New Court Decision Prompts Websites to Revise their Terms

November 7, 2012,

As a Silicon Valley corporate attorney, I work with a lot of Internet law and cyberspace law issues and am often asked by businesses to make sure their websites keep them free from trouble. Whether you are a large, multi-national corporation, a mid-size company, or a small business owner, chances are you run and operate a commercial website. One way to minimize the risk that comes from operating a commercial website is to create the conditions, sometimes called Terms of Use, that govern a visitor's use of the site. A court decision in September, however, found that website terms could be invalid and therefore fail to provide any protection to website operators. Because the court is located in the federal district that includes California, it is a critical decision that affects California website operators.

The case, In re Zappos.com Inc., Customer Data Security Breach Litigation, 2012 WL 4466660 (D. Nev. Sept. 27, 2012) arises out of Zappos' customer data security breach in January of this year. As is typical in a data breach situation, Zappos notified all persons whose personally identified information may have been compromised. When the inevitable lawsuit was filed, Zappos attempted to enforce an arbitration clause in the Terms of Use found on its website. A federal court in Nevada said "not so fast".

Some background is helpful. Terms of Use are often created with little thought, and can often be changed at any time by the website operator. They typically are submitted as a "browse-wrap" agreement, which, unlike a "click-wrap" agreement, does not require the user to click on a box to confirm the user's consent to the agreement. Browse-wrap agreements are usually referenced with an inconspicuous link at the bottom of a home page.

Courts have previously upheld website Terms of Use where users consent to them, such as in a click-wrap agreement, or where users knew about them, such as in a browse-wrap agreement. Like many things in the law, knowledge does not just mean that the user actually knew about the terms of use, but that the user was properly (or, in legalese, "reasonably") notified that the Terms of Use existed. As we will see, this is where Zappos ran into problems.

The court said the Zappos' Terms of Use failed for two reasons.

First, the court said that the Zappos Terms of Use were not set up to create a binding contract. The problem is that the link to the Terms of Use was not conspicuous, so a user would not have notice of its terms. The court said that a link that "is the same size, font, and color as most other non-significant links" will not work to form a contract. The court also noted that the website did not direct a user to the Terms of Use when creating an account, logging in, or making a purchase. Absent any direct proof that the user had read the Terms of Use, no contract existed.

Second, even if a contract was formed, the Zappos Terms of Use could be changed by Zappos, but not the user, at any time and without notice. Specifically, the court said that Zappos' ability to change the arbitration requirement allowed Zappos to change its mind about whether to arbitrate or litigate, notwithstanding the same option was not provided to users. In legalese, this meant that the arbitration clause lacked a "mutuality of obligation". The court looked to other federal courts that had examined the same issue, and said that this one-sided ability to follow a provision rendered the provision invalid, or, in legalese, "illusory". In other words, when it came to arbitration, there was not a deal. Therefore, Zappos could not enforce its arbitration clause.

In light of this case, any website operator should review its Terms of Use, preferably with the assistance of counsel, to make sure the website's Terms of Use can adequately protect the operator and business from liability.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Higher Taxes in 2013: The California Wood and Lumber Tax

October 24, 2012,

As 2012 is coming to an end, corporations and individuals alike are already thinking about taxes that they will need to pay at year-end. Every meeting I have with business owners lately somehow comes around to talking about taxes and how much I expect taxes to increase next year. The passage of Assembly Bill 1492 added yet another tax to the mix - the wood and lumber tax. This tax may affect homeowners, contractors and real estate developers.

We have all heard that ordinary federal income tax rates, currently maxing out at 35%, are scheduled to increase to 39.6%. Dividends could lose their special tax treatment and be taxed at this ordinary income tax rate as well. Federal long term capital gains rates will go from 15% back up to 20%. Payroll taxes may go back up from 4.2% to 6.2%. The AMT exemption amount may go back to 2010 levels. And high income earners will have an additional 3.8% Medicare tax. But on top of all that, starting January 1, 2013, those of us in California will also have to pay an additional 1% tax on the sales price of engineered wood and lumber products. (Assembly Bill 1492 (Ch. 12-289)).

Normally I would write this off as minor, but this year my husband and I are actually right in the middle of planning a huge fencing and deck project for our new house. (Did you know there was still residential land in the Silicon Valley that has not been fenced?) So, it was quite annoying to read about how this tax is going to be instituted on lumber, decking, railings and fencing as well as particle board, plywood and other wood building products, and even non-wood but wood-like products such as plastic lumber and decking. Even more so because it is already the middle of October and I'm pretty sure our project won't be completed until early 2013. So, if I buy all the wood before the end of the year, I save 1%... but probably end up with more than I need and the inability to return it. But, if I wait until January to buy it just in time to install it, I am going to hate paying that extra 1%.

The good news is that the tax will not be imposed on furniture or firewood, so at least I can wait to buy the new outdoor table and chairs and fill up the new fire pit.

[Source: Spidell's California Taxletter, Volume 34.10, October 1, 2012.]

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Tax Update: IRS Ruling Affects Automatic Gratuities

October 15, 2012,

Whether it is a group lunch to welcome a new employee to our law firm, a birthday dinner for family, or Moms' Night Out with friends, I often find myself enjoying Silicon Valley restaurants from San Jose to Palo Alto with a group of six or more. It is not uncommon to have the restaurant automatically add the gratuity, which is usually 18%, to our bill. This has always bothered me - not because I have a problem with paying the 18% (I often tip more than that), but because it is sometimes not obvious on the bill, and they still provide the blank line for you to add a tip, as if they are trying to trick people into double-tipping. Well, if you do not like the automatic 18% gratuity added to your bill, you will be happy to hear about a recent IRS ruling (Revenue Ruling 2012-18, June 25, 2012). This ruling clarifies the definition of tips verses service charges, each of which is treated differently for tax purposes. The result will likely be the end of automatic gratuities.

The IRS ruling states:
"The employer's characterization of a payment as a "tip" is not determinative. For example, an employer may characterize a payment as a tip, when in fact the payment is a service charge. The criteria of Rev. Rul. 59-252, 1959-2 C.B. 215, should be applied to determine whether a payment made in the course of employment is a tip or non-tip wages under section 3121 of the Code. The revenue ruling provides that the absence of any of the following factors creates a doubt as to whether a payment is a tip and indicates that the payment may be a service charge: (1) the payment must be made free from compulsion; (2) the customer must have the unrestricted right to determine the amount; (3) the payment should not be the subject of negotiation or dictated by employer policy; and (4) generally, the customer has the right to determine who receives the payment. All of the surrounding facts and circumstances must be considered. For example, Rev. Rul. 59-252 holds that the payment of a fixed charge imposed by a banquet hall that is distributed to the employees who render services (e.g., waiter, busser, and bartender) is a service charge and not a tip. Thus, to the extent any portion of a service charge paid by a customer is distributed to an employee it is wages for FICA tax purposes."

This definition may cause several different tax and reporting issues for restaurants, including:

- Restaurants can benefit from applying a general business credit toward employer side Medicare and Social Security taxes on tip earnings, which would be lost if these tips are considered service charges.
- Services charges will have to be reported as wages, affecting overtime rates.
- Services charges would be included in the restaurants calculation of Gross Receipts.
- Restaurants could choose to keep the service charge rather than pay it to employees.

So, next time you go out to eat with a large party, take a closer look at the check when it comes. I am guessing the automatic gratuities will soon change to something like a "suggested tip amount."

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Closing Conditions or Why Isn't the Future What I Thought It Was, Part 1

September 19, 2012,

Whether an acquisition is in San Jose, Cupertino, San Francisco, or anywhere else in California or the United States, any corporate lawyer will tell you that a buyer will not close a deal unless certain conditions are satisfied. Fortunately, closing conditions contained in mergers and acquisitions documentation have become standardized. Exceptions, however, always arise based on the unique attributes of the transaction, and standard does not always mean simple.

Some merger or acquisition closing conditions are standard and rarely require negotiation. For example, one of the standard closing conditions is that there is no injunction, law, or court order that prevents the transaction from proceeding. Outside of an actual known threat to a transaction, these clauses are rarely negotiated in a private company acquisition transaction.

Another standard closing condition is that the requisite corporate approvals will be secured. Because the respective Board of Directors of the each company will have approved the acquisition agreement, this is usually a noncontroversial item.

Similarly, stockholder approval is a standard condition but it can derail a deal if the company does not approach it carefully. Stockholder approval adds an additional wrinkle: dissenters' rights. These rights allow a stockholder to receive in cash the fair market value of its stockholdings, based on the value of the selling company, absent any change in value arising as a result of the acquisition. To receive this cash payment, the stockholder must vote against the acquisition. It is not sufficient for the stockholder to simply abstain from voting. To enable the stockholder to take advantage of its dissenters' rights, the selling corporation must provide notice of the right to exercise dissenters' rights, and the notice must contain specific provisions.

Why would the corporation want to allow one of its stockholders to have this right? To protect the transaction, that's why. Any stockholder who had the right to exercise its dissenters' rights, but failed to do so, can never attack the validity of the transaction. The only exception to this is if there was a problem with stockholder approval. In essence, dissenters' rights give the stockholder the choice between selling-out or going along with the deal. From the corporation's standpoint, it can feel comfortable that a transaction will proceed since all it has to do is buy-out its disgruntled stockholders.

Or can it? The problem with dissenters is that they have to be paid. If the deal is a cash deal, then the purchase price proceeds can be used to pay off the dissenters. If, however, the acquisition is a merger, where shares are going to be exchanged, the issue is tricky. Recall my discussion some time ago about an acquirer wanting to have working capital in the purchased company so that it can conduct business after the closing. Any payment to a dissenting stockholder will reduce the amount of the seller's working capital (assuming that the buyer will not use its own working capital to pay the dissenter).

The reduction in working capital arising out of a payment to dissenters will lead to a closing condition limiting the number of stockholders which can dissent to the deal. Typically, this number is less than 5% of the stock entitled to vote. Sellers who find themselves faced with such a condition find that a stockholder or stockholders holding a relatively small number of shares have, essentially, a veto right on a transaction. For this reason, executives of selling companies need to review their stockholder lists carefully to determine if there is any likelihood that a stockholder will exercise its dissenters' rights.

In my next blog, I'll discuss some of the other conditions that might crop up in a common acquisition deal.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.