The importance of conducting due diligence in an organized and exhaustive way cannot be overstated.  Failure to do so could lead the buyer to unknowingly purchase a company that is not viable under new ownership, or a company that is facing serious legal or financial issues. Therefore, to ensure the benefit of the bargain, the shrewd buyer should take full advantage of due diligence.

Having represented clients in both local business and multinational corporate acquisitions, I’ve realized that the due diligence process for each is surprisingly similar. That is because no matter the size of the target company, buyers have universal concerns about the target company remaining profitable under new ownership. 
 
Depending upon the nature of the transaction, such as in the case of a small business owner who does not want to upset the employees, the sale purchase agreement may require the buyer to conduct due diligence discreetly by, for example, visiting the business off-hours or by only contacting a designated individual for follow-up.  Due diligence may also require a personal visit to the target company, or even the seller opening all of its files for review in a designated place (usually a conference room or online on a secure website).

Ideally, a trusted professional should issue the due diligence requests, and then review all of the responsive documentation. An experienced attorney can be invaluable in that respect by knowing exactly what documents to seek, by helping the buyer to identify irregularities in the responses, and by drawing  the buyer’s attention to the important risks of the deal.  It may also be beneficial to have an accountant review the financial documents provided in due diligence to advise the buyer as to the target company’s financial health.

In order to capture the complete picture of target business for the buyer, the due diligence requests and documentary responses should at least address the following aspects:

Corporate Documents
The buyer should review and understand the implications of all of the governing documents for the target company along with minutes of the board of directors or shareholders, Certificates of Good Standing; stock certificates and stock ledgers.  That way, the buyer can understand how the company has operated and how it should continue to operate under new ownership.

Intellectual Property
Name recognition is always an issue.  Therefore, the buyer should review evidence of any trademarks, trade names, service marks, patents or copyrights that may be registered, pending, rejected, searched, or even contemplated by the target company.  The buyer should also seek a list of all know-how, trade secrets and technical information material to the target company’s business to make sure that the buyer will be able to continue to operate the business after the acquisition.

Furthermore, the buyer should analyze the way the target company has protected the intellectual property, and should review all contracts or documents relating to the protection of proprietary information such as agreements with independent contractors, confidential information policies and non-disclosure agreements.  Otherwise, the intellectual property may not be worth very much if it has been or may easily be disclosed to the public.

Material Contracts and Agreements
The buyer needs to know if the target company is contractually obligated or restricted from taking action after the acquisition, and whether or not the target company may assign all of its business contracts to the buyer as the new owner. For example, if most of the target company’s revenue stems from a service contract with a local government, the buyer should ensure that the target company will be able to continue providing services under that contract even after the buyer becomes the new owner.

It is therefore imperative for the buyer to review all of the contracts that affect the target company’s performance.  Some examples include the target company’s credit agreements, mortgage agreements, financial or performance guaranties, notes, indemnifications, sales & service agreements, non-solicitation agreements, non-compete and marketing agreements.

Litigation
Thorough due diligence includes a search to determine if the target company is subject to or even threatened by litigation that may be extremely expensive to defend.  While the claims facing the target company may be of little substance, the buyer should at least know what to expect, and to make sure that he or she is properly indemnified against the cost of pre-existing claims or litigation in the sale purchase agreement. 

Employees
The buyer should be able to identify at least the key employees to understand how each one contributes toward the target company’s daily operations, in addition to understanding how the employees are (and may continue to be) compensated. In that respect, the buyer should review all: employee lists, employment agreements, benefits policies, retirement plan policies and compensation schedules.

Financial Information
It is often advisable for the buyer to have an accountant review the target corporation’s income tax returns and financial statements to evaluate the target company’s financial health, to determine if there are any tax issues, and perhaps to advise if the purchase price is fair under those circumstances.

Property
Because the target company’s real and personal property may be the most expensive aspect of the deal, the buyer needs to know all of the details surrounding such property.  Buyers therefore often seek bills of sale, deeds, appraisals, depreciation schedules or restrictions on that property.

Insurance
The buyer or the buyer’s attorney should review all material insurance policies affecting the target company, and should ensure that the policies are appropriate and up-to-date.

Governmental Regulations
Finally, all target companies answer to a higher authority . . . the government.  Therefore, the buyer may request OSHA, EPA, IRS, EEO, or other governmental agency inquiries, as well as copies of all permits and licenses necessary to conduct the company's business.

After conducting due diligence, the buyer should have a full understanding of the target company and its relative value as a going concern.  If the buyer chooses not to conduct extensive due diligence, well, caveat emptor.

It is important that company’s Buy-Sell Agreement be reviewed periodically to make certain that it is properly customized to the needs of the specific company and its owners, as well as to make certain the agreement meets the requirements of current tax laws. Two of the most important areas of periodic review are the valuation provisions in the Buy-Sell Agreement and the funding of the buy-sell arrangement set forth in the Buy-Sell Agreement.. Valuation formulas based upon earnings can become obsolete and should be updated periodically based upon changes in a company’s accounting and compensation practices. Funding of the buy-sell arrangement should also be periodically updated to avoid a situation where there is a gap between the value of the company and the available funding.

Another aspect of the Buy-Sell Agreement that should be reviewed periodically is the agreement’s structure. Typically, Buy-Sell Agreements are structured as either a redemption agreement, a cross-purchase agreement, or hybrid agreement. It is important to review the structure of a Buy-Sell Agreement to determine if a different structure would be more beneficial in light of the corporate alternative minimum tax on life insurance proceeds. In addition there are also basis considerations to take into account when reviewing the structure of a Buy-Sell Agreement, in order to avoid serious income tax consequences.

Lastly, a periodic review of a Buy-Sell Agreement should include a careful review of the triggering events which either allow or require a transfer of ownership. While most Buy-Sell Agreements adequately deal with the death of an owner, it is equally as important to make sure that the Buy-Sell Agreement adequately covers other triggering events such as disability, voluntary termination of employment, involuntary termination of employment, bankruptcy of an owner, and the divorce of an owner.

When reviewing a Buy-Sell Agreement, it is important to take into account the unique needs of each company, the existing relationships between owners, as well as the individual functions of each owner. It is also important to do an analysis of the underlying economics of the company when considering an update of Buy-Sell Agreement.

Section 503(b) of the Bankruptcy Code allows administrative-expense status to all claims for "the value of any goods" received in the ordinary course of business by a debtor within 20 days before the bankruptcy filing. The supplier must request administrative-expense status. By doing this, the supplier is in a better position than unsecured creditors to be paid, since a Chapter 11 plan of reorganization cannot be confirmed unless administrative claims are paid in cash on the effective date of the plan. Unsecured creditors typically receive only a fraction of their claims.

Suppliers of goods have another method to be paid ahead of unsecured creditors. They may seek reclamation of goods sold to a debtor in the ordinary course of business under Section 546(c) of the Bankruptcy Code. A supplier must demand in writing reclamation of such goods not later than 45 days after delivery. Suppliers must move quickly or their right to reclaim will be lost. If the 45-day period has not expired as of the filing of a bankruptcy case, a supplier will have an additional 20 days after the filing of the case to demand reclamation of the goods sold. A reclamation demand is "subject to the prior rights" of a holder of a security interest in the goods sold.

• A transfer of copyright ownership, other than by operation of law, is not valid unless an instrument of conveyance, or a note or memorandum of the transfer, is in writing and signed by the owner of the rights conveyed or such owner's duly authorized agent.

To minimize disruption to the company’s operations and client relationships, a company can be proactive and have the key employee sign an agreement agreeing to certain restrictive covenants: 

Confidentiality Agreements. While an employee of your company, the employee will likely become familiar with confidential and proprietary information about the company, including its customer base, marketing strategies, supplier information and pricing of products. Confidentiality agreements require the employee to keep the business practices and operations of the company confidential both during and after the term of his or her employment. The confidentiality agreement should also require that the employee return and not remove from the company’s office, any confidential books, records, documents, lists, computer programs and other proprietary information. 

Non-Compete Agreements. This covenant restricts the employee from competing against the company for a certain time period, after the employee’s employment with the company is terminated.

Non-Solicitation of Clients. This covenant prohibits the employee from soliciting any person or business who was a current or prospective client during the employee’s term of his employment with the company. 

Non-Solicitation of Company Employees. This covenant prohibits the employee from soliciting any full or part-time employees of the company for purposes of inducing them to leave the employ or association with the company. In the event the departing employee intends to compete against the company, it will limit his or her ability to solicit other company employees to come work with the terminate employee. 

The enforceability of restrictive covenants generally depend on the geographical scope and duration of the provision.  In general, courts will only enforce restrictive covenants if they are reasonable in nature. Any restrictions on the terminated employee should be limited to only what is necessary to protect the company. For example, if the company’s clients and operations are limited to New Jersey, a court would likely scrutinize an agreement which contained prohibitions for any geographical areas outside of New Jersey, where the company does not operate. 

In addition, the enforceability of the agreement will likely depend on the jurisdiction in which the agreement is being enforced.  In certain states, restrictive covenants are generally unenforceable.   Even when they are enforceable, they are generally disfavored by courts because they interfere with a person’s ability to earn a livelihood. In some states, if a court finds that the restrictive covenant is overly broad, some courts may modify (“blue pencil”) the agreement to make it more reasonable (e.g., reducing the term of the non-compete from three years to one year).  

Provided that they are reasonable in nature, restrictive covenant agreements can be a useful tool to minimize the impact an employee can have on the company after his or her employment is terminated.

Technorati Tags: New Jersey : Restrictive Covenants

Lewis commented on the settlement between WalMart and the Department of Labor concerning improper overtime compensation for thousands of workers.

You can read the article here.

Before 1994, “S” corporations were preferred because of limited liability and flow-through taxation. For an “S” corporation to pay taxes through the shareholders directly, certain requirements are necessary. “S” corporations may only issue one class of common stock, other business entities and non-U.S. persons cannot be shareholders, and “S” corporations can have no more than 75 shareholders. Additionally, an “S” corporation is required to abide by sometimes rigid corporate practices to preserve limited liability, such as conducting meetings of shareholders and directors, maintaining minutes and making annual corporate filings. Also, shareholders of an “S” corporation can sell or transfer shares absent a shareholder agreement otherwise (subject to securities laws restrictions).

LLC’s combine the best features of a corporation (limited liability) with the best features of a partnership (flow-through taxation), while offering greater flexibility in management and ownership structure. An LLC is automatically taxed at the owner level without the need for corporate tax filings, unless the LLC elects to be taxed as a corporation. LLC’s may also have any number of members and those members may be other businesses or non-U.S. persons. The structure of the management of an LLC is more flexible, does not require duplication of paperwork and individuals playing multiple roles (shareholder and director), and is done with substantially less confusion.

Several LLC limitations have resulted in the continued viability of the “S” corporation. In an “S” corporation, a shareholder-employee pays self-employment tax on money received as compensation for services, but not on profits that pass through as a shareholder. Thus an owner can still be paid a salary, and only pay additional self-employment tax on the “reasonable compensation” portion of total distributions. The entire distribution drawn by an LLC’s member-employee is treated as a “guaranteed payment” meaning all payouts are subject to self-employment tax. The second factor is that if it is expected that the business will require institutional investment, most institutional investors will require that the business be a “C” corporation (versus an LLC or “S” corporation). An “S” corporation need only “unelect” their flow-through status to be treated as a “C” corporation to raise institutional investment, while an LLC would have to undergo a cumbersome conversion process.

Sorting through the characteristics of these business forms can be daunting for business owners, and making changes once a business is established can be difficult and costly. As such, individuals forming businesses should consult with legal counsel and accountants to review the characteristics of each entity important to their businesses.

Technorati Tags: New Jersey : Corporations

You can read the story here.

This week's New Jersey Legal Update is presented by Jason Storipan, member of Stark & Stark’s Employment Group.

You can download the New Jersey Legal Update Podcast # 55 here. (4.75 MB)

Technorati Tags: New Jersey : Podcast :  Employment

The presenters, Allen Silk, Chair of Stark & Stark's Business Law group, Donald Cowan, Managing Director of Cowan, Gunteski & Co., and Deborah Mathis, Principal of Cowan, Gunteski & Co. will cover such topics as succession planning, practice valuation and retirement planning.  

Download the seminar information here.

Read the chapter here.

This week's New Jersey Legal Update is presented by Thomas Onder, a member of Stark & Stark’s Franchise and Creditor's Rights Groups.

You can download the New Jersey Legal Update Podcast # 49 here. (7.8 MB)

Technorati Tags: New Jersey : Podcast : Franchise : Creditor's Rights

This week's New Jersey Legal Update is presented by David Krulewicz, a member of Stark & Stark’s Employment Litigation Group.

You can download the New Jersey Legal Update Podcast # 48 here. (11.5 MB)

Technorati Tags: New Jersey : Podcast : Employment

This week's New Jersey Legal Update is presented by Adam Siegelheim, a member of the firm's Franchise Group, and John MacDonald, a member of the firm's Litigation Group.

You can download the New Jersey Legal Update Podcast # 45 here. (11 MB)

Technorati Tags: New Jersey : Podcast :  Franchise

In the franchise world, non-competition agreements typically enjoy more protection from the Courts because of the specific nature of the business transactions between franchisor and franchisee. It is doubtful, however, that Courts will extend similar legal “extra credit” to franchisors attempting to enforce non-competition agreements against franchisee relatives because they are too legally “distant” from the initial transaction. Therefore, franchisors should have reasonably limited expectations when they attempt to enforce such agreements with franchisee spouses and relatives. On the other hand, it is fair to assume that requiring franchisee relatives to execute such agreements may act as a significant deterrent to “end runs” around franchisee non-competition agreements.

You can read the article here.

Lewis commented on the case, saying he feels it would be difficult for the nurses to prove their case.  You can read the article here.

The New Jersey Supreme Court was recently faced with a similar issue in the case of NCP Litigation Trust v. KPMG, LLC., A-19 September Term 2004, decided June 28, 2006. In the NCP case, the New Jersey Supreme Court held that auditor responsibility was not limited to only auditors who actively participated in the corporate fraud. The Court found that independent auditors can be held liable for a corporate client's fraud, even if they did not participate in or have direct knowledge of the misconduct. The New Jersey Supreme Court expressly declined to follow the Illinois decision in Cenco Inc. stating that Cenco was decided more than 20 years before and that "events since then suggest that auditors must be more alert to corporate fraud and, where appropriate, courts should take steps to protect and safeguard the public from that fraud". The New Jersey Supreme Court indicated that it was writing "...under a clean slate in addressing the issue under New Jersey law. "

The NCP case involved a fraud committed by the chief financial officer and chief executive officer who provided the auditor with fake numbers to artificially inflate the company's stock value and thereby bolster the CFO's financial stake in the business. The company eventually filed bankruptcy and it's shareholders sued the auditor for malpractice claiming that the auditors knew or should have known of the CFO-CEO's fraudulent activities.

The auditor defended the suit on the basis of the "imputation doctrine", which generally protects third parties from suits involving corporate wrongdoers. The Court held that the auditor may have had an independent contractual obligation to detect the fraud, which it allegedly failed to do. The "imputation doctrine" was designed to protect the innocent and the Court found that relieving the auditor of liability would not promote the purpose of the doctrine.

Justices Jaynee laVecchia and Roberto-Soto wrote dissenting opinions stating that the "imputation doctrine" should apply, especially because the auditors in this case were not aware of and did not participate in the creation of fraudulent financial data.

Technorati Tags: New Jersey : Imputation Doctrine : Corporate Fraud

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