Your Diligence is Due: Analyzing, Understanding, and Planning for Pending Litigation Risks in M&A
In the M&A world, typically the CFO’s role is to facilitate the due diligence process and to identify significant risks that could impact the deal or impact the company post closing. Pending litigation at either the buying or selling entity can have a range of impacts on a deal. Potential effects of outstanding litigation matters may include impacts on issues related to:
- Timing of the deal: The buying and selling parties may have to wait for arbitration, settlement, or judgment.
- Pricing: Reserves or allowances for judgments will likely impact purchase price, and the transaction structure itself may be impacted if an earn-out or contingency deal is struck.
- Scope of due diligence: Attorney/client privilege can place limitations on the scope of further due diligence efforts.
In the end, pending litigation may be cause for simple reevaluation or minor renegotiations, or they may render the entire transaction infeasible. And while applause may go to those deal teams capable of crafting alternative or “creative” deal structures to mitigate the impacts of pending legal action, in our experience, such cases may require even more business and risk analyses to determine whether the issues have actually been resolved or whether new ones have been created.
Innovative transaction structures aimed at facilitating deal close can sometimes confound business rationale by triggering complex accounting rules that make the deal less attractive or by compromising the legal position of the defendant(s) (e.g., inadvertently setting a floor for damages). Therefore, CFOs should seek multiple points of view as they evaluate the financial implications associated with the deal.
Resolving the paradox
Paradoxically, some buyers and sellers actually create new legal, accounting/finance, or business issues in their quest to mitigate existing ones. To avoid getting caught in this loop, we recommend that dealmakers consider a structured framework for analyzing outstanding litigation risk, while also exercising that same level of diligence on any potential deal structures/proposals intended to insulate parties from exposure.
It’s important to remember that effective due diligence teams are not finished once they have identified litigation exposure, or even after recommending ways to mitigate it. The team should follow through by carefully analyzing each recommendation as they can impact litigation, trigger accounting rules that affect the deal, and draw heavier scrutiny from key stakeholder groups (IRS, SEC, Wall Street, and others). All these potential outcomes can stretch the transaction timeline—and impact deal costs—considerably.
Here is a buy-side example of our recommended approach for analyzing outstanding litigation risk:
- Inventory all legal exposures. This inventory should include pending and threatened actions; criminal and civil suits; and suits/investigations by government bodies. 1 While public companies are required to disclose pending litigations in their SEC filings, this task may be more challenging for privately held companies. For both public and private companies, we recommend performing your own due-diligence on the litigations to arrive at a fact-based assessment of potential exposure. When compiling the inventory, consider:
- Materiality threshold. Establish a materiality threshold according to deal size, likelihood of follow-on suits, etc.
- Relevant information. For each matter, summarize:
- Parties involved,
- Nature of proceedings; date commenced; likely timing of future hearing/trials,
- Status, relief sought, settlements offered,
- Sunk costs; estimated future costs,
- Relevant insurance coverage, and
- Any legal opinions rendered on these actions.
- Correspondence. Include copies of correspondence with government agencies/regulatory bodies.
- Estimates. Evaluate each claim and quantify potential liability or recovery. (If possible, seek legal counsel to determine whether this can be done. Also, assess the risks of quantifying potential damages, such as producing facts or figures that could be detrimental during a discovery phase.
- Potential impact. Determine whether a deal will compromise current strategy for ongoing litigation.
- Define transaction impacts. Consider the potential impact of:
- Fraudulent conveyance concerns. Will plaintiffs be likely to pursue injunctive relief and block the deal?
- Deal closing timeline. Will this push the company beyond any transaction deadlines that have been promised? Will this cause the company to miss an earnings target?
- Impact on sale price. Are there liabilities or expected legal fees putting pressure on the offer price?
- Deal structure (cash vs. debt vs. stock, earn-out). Is the legal exposure already baked into the target’s share price?Does the deal need to be structured in such a way that the litigation proceedings can play out over time?
- Leverage “fresh experts.” Utilize new participants experts on the due diligence team and their objective perspectives to investigate legal alternatives and deal approaches. Their evaluation should include the ability of each option to successfully mitigate litigation risks and impacts, including the pros and cons of:
- Settling out of court. Identify and manage costs, publicity, and timing issues.
- Indemnifying parties to the deal. Anticipate how plaintiffs may respond—are their rights protected so they won’t try to block the deal? Also be aware of equal consideration rules and potential accounting implications.
- Sharing the end result. Evaluate the impact of a judgment sharing arrangement on the financial statements—does such an agreement create a contingent liability or guarantee? Be sure to address the appropriate accounting rules (FAS 5, FIN 45, proposed FASB revisions to FAS 5). Also, consider whether the defendant’s position may be put at risk.
- Adjusting purchase price. Identify all the factors to be evaluated, such as contingencies, liabilities, guarantees of indebtedness, etc. Also spend time evaluating the potential risk of subsequent lawsuits.
- Changing structure/timing of payment. Assess whether an earn-out arrangement can be pegged to future performance, including results and costs of litigation. Again, determine whether such a structure has associated accounting requirements.
- Tabling transaction until litigation is resolved. Consider the merits of waiting it out to avoid the litigation concerns, but also identify business/competitive risks to missing a deal opportunity.
- Don’t commit until due diligence is complete. Sign the definitive agreement and announce the transaction publicly only after due diligence reviews firmly establish that the deal will be executed; do not paint yourself into a corner by announcing something before reaching near certainty that the deal can be pursued. Seeking counsel from more additional advisors can be expensive and add time, but when looking at the financial impacts, it is usually money well spent. It is better that you delay so that you don’t have credibility issues.
Real-world example of litigation affecting a sell-side transaction
As senior management prepared to sell a division, they devised a transaction structure to separate the division from the parent organization and remaining businesses. But during later-stage reviews they discovered an obstacle: a lawsuit naming the parent and a different business unit—which was not party to the proposed transaction—as defendants. (Naming both a business unit and parent as co-plaintiffs in a suit is typical in order to lay claim to all resources available for funding a judgment.)
If the parent proceeded with the sale as planned, the company would have been at risk of committing fraudulent conveyance, which is the transfer of title to real property with the intent to avoid possible claims against the property. 2 Plaintiffs may have interpreted this action as a tactic for protecting assets from the judgment, and they could have filed a motion to block the deal.
Although the lawsuit and proposed deal structure posed significant challenges, aborting the transaction was not an option since management had publicly announced their intention to do the deal. Developing an alternative approach was critical to avoid stock price decline and shareholder pressure.
The parent and its team of advisors began outlining deal alternatives and studying the advantages and drawbacks of each. The company investigated two primary options for resolving the dilemma, carefully weighing the answers to these key questions:
- Indemnifying parties to the deal. How will plaintiffs in the lawsuit respond? Are their rights protected such that they won’t make efforts to block the deal?
- Sharing the end result. Does crafting an agreement outlining how the eventual judgment might be shared create a contingent liability or guarantee? If so, are there accounting rules that need to be addressed? Could the defendant’s position in the suit be put at risk? And finally, what are the implications to the purchase price?
What eventually happened? The company incurred significant delays and cost overruns by not understanding the full impact of litigation issues and the potential approaches for handling them. The parent’s reputation in the investor community was put at risk by announcing a deal structure and timeline in advance of having completed adequate due diligence.
While the situation was complex, more robust due diligence, as defined in the structured approach above, at the outset of transaction planning would have included scrutiny of not only the existing legal issues, but also of the proposed approaches for handling such matters in the context of an M&A transaction. With the appropriate focus on due diligence, these issues could have been identified much sooner, saving time, money, and organizational energy.
1“The Art of M&A Due Diligence.” Lajoux, Alexandra Reed; Elson, Charles. McGraw-Hill, 2000.
2 www.legal-explanations.com .
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