In the current economic crisis and its aftermath, clients have very often remarked to us that although litigation is not a strategy they would choose, lessons learned from legal disputes tend to make them much better businesspersons in future transactions. This seems particularly true for business brokers involved in marketing opportunities arising out of restructured companies for at least two reasons. First, although business brokers are not directly charged with many of the tasks where a lack of performance leads to failure, they are obviously motivated to facilitate a successful closing, and directing the attention of those specifically charged with such tasks to certain pitfalls can increase the chances of a commissioned sale. Second, if the sale of a restructured company does occur, then retaining the commission and staying out of post-closing lawsuits because of mistakes later found should be an important objective.
With these considerations in mind, here are ten of the more common pitfalls, one might say “Lessons Learned,” for which business brokers (as well as business principals) should be on the alert.
- Following Through With Full Document Execution.
We have found that in complex restructuring transactions with a multitude of interrelated documentation, full execution of all instruments is often overlooked and this can taint the integrity of the entire deal. For example, sometimes the basic agreements call for the execution of supplemental documents such as a personal guaranty, but if the latter isn’t generated or isn’t fully signed, this can lead to huge problems. Even when experienced professionals are involved, such follow up work can fall through the cracks. In one situation, lawyers (at another firm) drafted all of the documents and sent them to the client for circulation and execution but the client misunderstood and the documents remained in its files, uncirculated and unexecuted. Such simple but critical mistakes can prove fatal.
- Draft Release Language Carefully.
Agreements often have release clauses but lawyers will frequently use old forms with boilerplate language that is not tailored to the risks of the transaction at hand. It can prove to be too narrow or it can be too broad – e.g., as in covering all future misconduct that may not even have occurred yet, which the parties may not intend to release before knowing what it turns out to be. Note also that even in an extensive, forward-looking release clause, future fraudulent misconduct cannot be released under California law.
- Attention To Conflicts of Interest Among Entity Decision Makers.
Managing members of an LLC can become ensnared in potential or actual conflicts of interest when they approve terms or sign documents on behalf of an entity and yet at the same time are receiving benefits – or assuming burdens – in their individual capacities. Guaranties of notes signed by the entity are one example, approval of management fees or other compensation arrangements are another example, and certainly exculpatory or indemnification clauses related to future management acts or omission can fall under this category.
Conflicts of interest can, of course, render an entire transaction vulnerable if self-serving or breaches of fiduciary duty by a member should occur, even if there is good faith, because the legal standard for evaluating such conflicts is not what the subjective intent was but, rather, whether in fact there were conflicting interests.
- Attention To Which Party Legal Counsel Actually Represents (And Who They Do Not Represent).
When companies are restructured, and particularly when they are newly formed, questions arise as to who the lawyer drafting the documentation actually represents. Before the entity is legally formed, or when new money investor members are admitted, issues can arise as to whether the lawyer can represent that yet-to-exist client, and certainly the legal fees are often advanced or even paid by the forming principals. This issue is critical with regard to preserving confidentiality of communications, keeping track of the duties of loyalty and/or conflicts of interest of the lawyer, and even assessing who owns any malpractice claims.
- Capital Call Provisions.
Many Operating Agreements fail to recite what happens if the company runs out of money but still needs operating cash and/or money for defense costs if a post-closing lawsuit is filed against it. In the absence of such a provision, the company can actually be defenseless because although managers are often enabled by the Operating Agreement to loan funds to the entity, they have no obligation to do so (and conflicts of interest could be created even if they do). So it may make sense to insert a provision calling upon members to contribute monies for limited critical needs. In addition, remedies for failure to contribute should be considered and spelled out (i.e. dilution of membership interests).
- Personal Guaranties.
Members are very often called upon to provide personal guaranties of the obligations of an entity, but arranging such a feature of a transaction can be complicated and this is frequently mishandled. Clearly the rights of multiple guarantors against each other for contribution need to be addressed, particularly the risk of one or more of the guarantors later becoming insolvent. The guaranty documentation itself must also be carefully drafted to anticipate risks of exonerating conduct. Under California law, changes in the debt can eradicate the guaranty obligation and boilerplate waivers of such exoneration rights are often not well constructed, leaving many loopholes which can greatly undermine the effectiveness of personal guaranties.
- Keeping Information Privileged (And The Many Dangers of Using Email).
Information communicated between principals of a company being restructured and the company’s lawyers is generally privileged, but it does not necessarily follow that communications between the principals themselves are protected. In any event, communications between the principals and the lawyers about issues beyond advice by the lawyer to the company might not be shielded. Further, even if privileged status is given to communications, sloppy email practices can waive the privilege – such as for example when an attorney’s email is forwarded to a third party who is not a principal of the attorney’s client. Since attorney communications about strategy can be highly sensitive, creating privileged status and retaining it is a critical endeavor.
- Default Provisions.
One of the most common mistakes in restructuring documentation comes in the form of inadequate default provisions. Here, if certain conditions are not satisfied then a question arises as to what the rights of the parties may be. In one case, certain investors inadvertently failed to execute key documentation, but a poorly worded default provision created a loophole for them to argue that they were able to get out of their obligations altogether because it recited that they could then rescind the deal rather than being required to follow through and execute the documentation.
- Directors and Officers Insurance.
In today’s business environment, suits against directors, officers, and managers are not uncommon and so it behooves all parties concerned to investigate D&O coverage opportunities. Claims of breaches of fiduciary duty and conflicts of interest are obviously serious, both as to substantive exposure and as to the high costs of defending even unmeritorious suits. The cost of insurance coverage often proves to be a bargain if a complex transaction goes awry.
- Read Documents Carefully and Consider Consulting Independent Counsel. Key documents such as Operating Agreements and guaranties are common and often just copied automatically from off-the-shelf boilerplate form agreements used in the past on other deals. Many people try to save legal costs and/ or to find safety in such a “tried and true” approach but substantial dangers lurk for those who do not read these documents carefully. No assumptions should be made about whether they have been sufficiently tailored for the transactions at hand, or as to where the true loyalties of the attorneys drafting them may actually lie. The most prudent choice may well be to retain one’s own independent counsel for such scrutiny as a modest legal fee today can save sums many times greater than that expense. This also has the advantage of sparing the parties from future distractions and deteriorations in important business relationships that can jeopardize future deals.
In the end, the prudent business broker, even though not a lawyer and even though not in charge of the documentation process, has an important role in at least alerting the professionals to some of the pitfalls. There is probably no such thing as excess caution in a high-stakes restructuring transaction.