Legal Pitfalls in the M&A Process

Navigating legal pitfalls is a challenging exercise during the acquisition process. While most issues are ultimately resolvable, it should be a goal of all parties involved —including sellers, buyers, attorneys and advisors — to work together to complete the transaction successfully. Awareness of potential concerns allows all parties to plan, mitigate and ensure that the acquisition transaction process runs as smoothly as possible. 

While a selling company may be aware of some of its legal and liability issues, the seller may not be aware of how it may impact a potential buyer. Typically, existing issues will surface when the buyer goes through the due diligence process, which involves a thorough investigation by the buyer of the seller’s business to confirm facts or details that the seller has represented. 

Due diligence requires examining many aspects of the business, including financial records and operations of the selling company. It usually occurs after a nonbinding letter of intent has been signed by both parties. 

The buyer wants to confirm that it is buying the business that it thinks it is buying and uses this process not only to detect potential legal and operational issues, but also to find out information that will help it in its integration of the business after the transaction.  

Pre-Transaction Planning

For a seller who knows that it will be selling in the near future, it is recommended that any outstanding legal and compliance matters are resolved before putting the company on the market. If there is pending or threatened litigation, the seller should try to resolve as much of this as possible before marketing the company. A buyer may be concerned that unresolved matters could lead to future loss of customer goodwill.   

In due diligence, the buyer typically requests information on safety, compliance and customer contracts. The buyer will review customer files to see if there are contracts with customers leasing storage tanks from the company and if the seller can verify that it owns the tanks at customer locations. The buyer will want to confirm that tank inspections, “duty-to-warn” notices, training certificates related to Certified Employee Training Programs, Department of Transportation files, and other compliance matters are correct and in good order. 

A transaction goes much smoother if these items are addressed before marketing the business for sale. Tank ownership is particularly important in the propane industry. If the seller cannot prove tank ownership, it may result in the buyer holding a significant part of the purchase price in escrow until ownership is confirmed.
   
It is always beneficial to have the seller’s books, records and organizational documents in good order and up to date as well. Formation documents of the company will be asked for, and in larger transactions, copies of corporate minutes and board resolutions will be requested. Quite often, especially in smaller companies, many of these documents are held at the office of the company’s outside counsel. Collecting these documents may present a concern if a company has changed attorneys over the years. 

Due Diligence

Once the letter of intent is signed for a purchase and sale transaction, the formal due diligence period begins. Though rigorous, by presenting detailed information before marketing a business, the seller will be better positioned to propose mitigation measures that can lead to a successful sale. In addition to financial due diligence, the buyer usually performs diligence regarding customers, compliance, environmental matters, human resources, material contracts, technology, intellectual property, litigation, cybersecurity, real estate, insurance and general corporate matters. Although all of the above items are important, let’s focus on three potential due diligence issues: environmental issues, material contracts and cybersecurity.

1. Environmental Issues

Generally, if the seller has a bulk plant consisting of propane storage only, environmental due diligence will not be a major area of concern. However, if there is a bulk plant with storage for heating oil, diesel or gasoline, the due diligence can be extensive and time-consuming. 

For these multifuel facilities, the standard is to perform an American Society for Testing and Materials Phase I Environmental Site Assessment (ESA), which researches past use of the property or current Recognized Environmental Conditions (RECs) for conditions that diminish the value of the property. Phase I could take several weeks to complete, as it can take weeks to access environmental files at a state level. The ideal outcome is that Phase I comes up clean. If the report comes back with areas of concern or RECs, then a Phase II environmental report is usually required, which could add weeks to the closing. Worse yet, if contamination is discovered, it could lead to the buyer backing out of the deal. However, even if contamination is found, it can often be handled by escrowing money as part of the purchase and sale agreement once its extent is delineated. 

2. Material Contracts

Perhaps the most extensive aspect of due diligence is reviewing all of the seller’s material contracts. The buyer will want to know the seller’s commitments and determine if it wants to assume them. Contracts of major concern are customer and supplier contracts, employment agreements and agreements from previous acquisitions or divestitures that limit the territory the seller can be active in or restrict the seller’s product line. Additional contracts to review include real estate purchase agreements, leases and insurance contracts. Issues often arise with master agreements for propane supply contracts. For many selling companies, the master agreement may be over 10 years old and misplaced. 

Sellers are reluctant to ask the supplier for a copy of the master agreement contract for fear that it will start a rumor that the company is for sale. However, ultimately, a copy will probably need to be provided as supply contracts usually require the supplier to consent to the contract assignment. In some cases, the supplier may not want to extend the same credit terms to the buyer as it did to the seller, which can also cause delays. 

3. Cybersecurity

The extent of the buyer’s diligence on cybersecurity will depend on whether the buyer will continue to use the existing networks and systems post-closing. The buyer wants to be assured that any existing data compromises that the seller may not be aware of do not penetrate the buyer’s systems or continue after the closing. The buyer will need to understand the network’s architecture and how data flows. 

Usually, there will be third-party consultants on both parties’ sides involved in this diligence phase. If the buyer plans to use the seller’s network and systems after the transaction closes, it is important to know if third-party providers require the consent of software and network services. 

If the third party is allowed to charge a fee for the transfer of a software license, it often becomes a point of negotiation to determine which party, buyer or seller, will pay the fee.     

Other Concerns

The issue of asset allocation is more prevalent in propane transactions than heating-oil transactions due to the value of company-owned tanks at customer locations. Typically, the seller wants to have the lowest number possible allocated to hard assets, since capital gains will be taxed at lower rates. Sellers also look for a low number on noncompete agreements, as its payment comes to the owner as ordinary income and is taxed at higher rates. The seller wants the customer list to be as high as possible since it’s typically taxed at lower capital gains rates. 

Meanwhile, the buyer prefers a high allocation on the vehicles and propane tanks since the seller is allowed to take a “stepped-up” basis on its newly acquired assets, resulting in greater depreciation post-closing, allowing a deferral of future tax payments. Negotiation of the purchase price allocation can often be challenging and delay the closing.

Another issue that can arise is the scope of noncompete and nonsolicitation agreements. Not often an issue if the seller is retiring, it may be an issue if the seller has children working for the company. While the seller wants to provide as much flexibility to the children as possible, the buyer does not want the seller or their children competing against the buyer in the same market. 

Typically, noncompete and nonsolicitation of customers and employees agreements are effective for three to seven years. The size of the restricted area ranges from the current market area served by the company to sometimes all of the states in which the seller markets to customers. 

Other items can also disrupt a transaction. The seller should be willing to engage competent professional advisors experienced in purchase and sale transactions to ensure a good price for the business and increase the chance that the deal will close. 

A transaction process will be much smoother for the seller by planning for the buyer’s due diligence. Anticipating legal and due diligence issues always leads to a more successful transaction for both the buyer and the seller. 

Research Data

1. A Comprehensive Guide To Due Diligence Issues In Mergers And Acquisitions (forbes.com)
2. 7 Mistakes to Avoid When Buying a Business | M&A Lawyer (cenkuslaw.com)
3. 7 Costly Mistakes to Avoid When Selling Your Business (cenkuslaw.com)
4. Top Ten Issues in M&A Transactions – Mergers Acquisitions (morse.law)
5. Environmental Due Diligence (currenenvironmental.com)
6. Explaining Legal Side of Mergers and Acquisitions Transactions (dealroom.net).