New episode of our video podcast, Speaking of Litigation: When a merger or acquisition closes, many executives assume the legal work is over.
But as this episode of Speaking of Litigation reveals, signing on the dotted line may be just the beginning.
Avoid post-closing litigation with these issues in focus:
- Earnout Disputes: Learn how a buyer’s actions can intentionally or unintentionally depress earnings, leading to legal battles over unpaid contingent payments.
- Indemnification Risks: Understand why a buyer’s “safety net” can become a legal landmine for sellers, especially when ambiguous deal language is involved.
- Regulatory Surprises: Discover the unforeseen challenges that arise when government investigations begin after a deal closes, forcing buyers and sellers to confront liability for past conduct.
Epstein Becker Green attorneys Jim Flynn, Bob Travisano, and Daniella Lee discuss how to spot the red flags in a deal, the main legal triggers of post-merger disputes, and, most importantly, how to protect your business—whether you’re the buyer or the seller.
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Transcript
[00:00:00] Jim Flynn: Today on Speaking of Litigation, we're discussing post-merger and post-acquisition litigation. Most people assume that once the deal is done, the deal is done. There's no additional legal work to do. But that's not always the case. And we've seen that in certain high profile post-merger disputes like those depicted in Barbarians at the Gate, which was a famous book and a less famous movie.
[00:00:28] Jim Flynn: We've seen that in Michael Lewis' writings about the money culture. We've seen it in fictionalized films and also in TV shows, like one of my favorites, Succession. And of course, many of our viewers may have faced issues with less drama or fanfare, but there's still a lot of risk. So we're going to dive into some core triggers of post-merger and post-acquisition litigation, such as earnout disputes, how former equity holders claim they're shortchanged.
[00:00:57] Jim Flynn: We're going to talk about liability versus damages. We're going to talk about risks associated with ambiguous deal language, and we're going to talk about some of the regulatory surprises that may confront both buyers and sellers when government investigations kick in after a transaction. Hello everyone. I'm your host today, Jim Flynn.
[00:01:17] Jim Flynn: I'm an attorney at Epstein Becker and Green. I'm in the litigation department. I'm also the managing director of the firm, and I'm based here in our Newark, New Jersey office. Shareholder and deal related suits are quietly rising post-closing. They're rising around issues of due diligence misses and earnout disputes.
[00:01:37] Jim Flynn: It's often important because the value of a deal is not always measured on the day of the closing, and that's not always when you get paid all the money you're owed for that deal. Sellers sometimes have to wait for the money as it's held in escrow or subject to earnouts, and buyers have to fulfill obligations to share money, to share information, and to deal in their own stock in periods after the closing.
[00:02:02] Jim Flynn: And since everybody has lawyers helping them out, disputes can become inevitable. Joining me today are two of my favorite people. One is Bob Travisano, a member of the firm in our Newark office, a seasoned litigator. And someone that I've worked on earnout disputes with and I'm currently working on some post-merger matters with.
[00:02:25] Jim Flynn: Bob, welcome to your first episode of Speaking of Litigation.
[00:02:28] Bob Travisano: Thanks very much, Jim. It's great to be here with you. Not coincidentally, one of the most memorable parts of my legal career so far has been arbitrating a post-closing dispute with you. And you know, not just because we won, was it memorable, but because of a lot of other side stories that happened during that, including you drawing out a code red moment from one of opposing side’s witnesses, and arbitrating it in a hundred degree arbitration room because the air conditioning broke in the middle of the proceeding. Hopefully today will be a little bit cooler than that.
[00:03:01] Jim Flynn: Well, I hope so too. We also have with us Daniella Lee, a member of our firm in the Tampa office who is also debuting on Speaking of Litigation. Daniella and I have worked together on one of these types of cases that had some added wrinkles that our listeners may find of interest. Daniella, welcome.
[00:03:18] Daniella Lee: Thank you so much for having me, and I'm really looking forward to discussing these issues, especially some of those wrinkles that can arise if there's a post-closing government investigation, or when buyers discover regulatory compliance issues that may not have been caught during diligence.
[00:03:33] Jim Flynn: So let's jump in, and Bob, let's start with a big picture. The deal's closed. Why do disputes even come up between a buyer and a seller after that?
[00:03:42] Bob Travisano: Sure. Well, it's a big misconception that the deal close ends the story, but in reality, a lot of other obligations survive, especially in the context of earnout provisions and indemnification terms.
[00:03:54] Bob Travisano: These can really be ticking legal time bombs. You hope they don't go off, but if they do, things can get quite dicey.
[00:04:00] Daniella Lee: So the ink dries and then the financial realities start to kick in. So the buyer may claim that the seller misrepresented revenue, or the seller may argue that the buyer is mismanaging the business to avoid having to pay the earnout.
[00:04:12] Daniella Lee: You'd be amazed how often the fights come down to either ambiguous contract terms or hard to measure financial targets.
[00:04:18] Jim Flynn: So let's break some of this down. We've heard a couple of terms here. I'm going to ask Bob to start with “earnouts.” What are they? And why do they become contentious?
[00:04:29] Bob Travisano: Sure. An earnout is typically a contingent payment tied to the target company's performance following the closing of the deal.
[00:04:37] Bob Travisano: For example, if revenue exceeds a certain threshold, the seller gets a bonus. The idea behind, the rationale behind these types of provisions is to bridge the gaps between when the seller and buyer can't agree on a solid purchase price.
[00:04:52] Jim Flynn: Well, that sounds pretty fair. So Daniella, where do the problems come in?
[00:04:58] Daniella Lee: Typically control and measurement. So the buyer now owns the business so they can restructure operations, they can delay projects, they can reallocate resources in ways that might temporarily depress earnings, whether intentionally or not. And the earnout is, if it's based on net income or EBITDA, sellers may argue that it's being manipulated to avoid triggering that earnout payment.
[00:05:22] Jim Flynn: Well, you seem pretty good at explaining these, so tell us what indemnification is. What kind of issues pop up there?
[00:05:28] Daniella Lee: Sure. So indemnification is essentially the buyer's safety net. So if the seller misrepresented something in the reps and warranties, say they claimed they were in compliance with health care regulations and health care laws, but the buyer discovers that there were issues that may warrant an overpayment refund or self-disclosure to OIG or even to DOJ.
[00:05:47] Daniella Lee: The buyer can make a claim to recover losses associated with that. But it can get messy quickly. We have to watch for things like, did the buyer give timely notice of their indemnification claim? Does the claim fall during the survival period? Is it above the deductible but below the cap for indemnification, and is the breach of a particular rep or warranty in dispute?
[00:06:11] Daniella Lee: Also, there's typically a fight about whether the losses are actual or contingent and whether or not they were foreseeable.
[00:06:18] Jim Flynn: That's really helpful, Daniella, and we'll come back to what the DOJ, Department of Justice, or OIG, Office of Inspector General, do as we get later into the discussion. But Bob, let's come back to you right now.
[00:06:32] Jim Flynn: Okay, we understand earnouts, we understand indemnification. Do you ever see indemnification obligations used tactically, like holding up, you know, payments to squeeze the sellers or to get out of payinge verything that's owed?
[00:06:48] Bob Travisano: We sure do. And typically these arise in private deals where the sellers are individuals or small groups.
[00:06:56] Bob Travisano: Buyers may lodge borderline claims just to offset part of the purchase price or tie up the escrow until the limitations period runs out. Essentially, it becomes a total leverage play at the end of the day.
[00:07:07] Daniella Lee: And if you're the seller, you're going to wanna fight to limit what can be withheld in escrow and for how long. You're also going to want to insist on really well-defined claim procedures with time limits.
[00:07:18] Jim Flynn: Got it. Alright. Let's dive a little deeper into the earnout question now that we have the basic terms kind of squared away, Bob, if an earnout dispute makes it to litigation, or as you mentioned before, arbitration, like the one we had.
[00:07:32] Jim Flynn: What are the most likely claims that come in and have to be made, and how do you go about proving them? How's that dealt with?
[00:07:39] Bob Travisano: Sure. Well, oftentimes we're going to see breach of express contract terms, such as what were the representations or warranties in a merger or sale agreement and whether or not they were breached.
[00:07:49] Bob Travisano: But the express terms don't always necessarily capture what's needed from a factual or legal standpoint. So we'll also likely see claims for breach of the implied covenant of good faith and fair dealing.
[00:07:59] Jim Flynn: I appreciate both of you actually keeping your guns and your holsters and not objecting as litigators do, to my compound questions, but I'll try to be a little more straightforward as I turn to Daniella.
[00:08:10] Jim Flynn: Picking up on this concept of the implied covenant of good faith and fair dealing, can you explain what that is?
[00:08:17] Daniella Lee: The covenant of good faith and fair dealing is an implied promise that's read into every contract that says that both parties must act honestly and not unfairly prevent the other party from being able to receive the benefits of the contract.
[00:08:30] Daniella Lee: So they arise in this context because proving that the buyer manipulated performance numbers or slow played integration is rarely as easy as looking at a single contractual provision. It's usually a broader argument and requires a broader set of proofs too.
[00:08:45] Jim Flynn: So talking about proofs, what kind of discovery battles happen in these cases, and if you can, in your response, tell us about access to internal emails, pre-closing, post-closing, board minutes, what are we looking for in these types of cases, Daniella?
[00:09:04] Daniella Lee: There is frequently a lot of discovery between the parties on what efforts were made by the buyer to meet any of the performance goals that were set. So there's a lot of fact and expert evidence presented about accounting and expenses and about how the performance was actually monitored and documented.
[00:09:22] Daniella Lee: But really the trickiest part is often related to third parties, and that's because customers and potential customers are often the best source of accurate information as to what earnout efforts were made. But buyers and sellers are often very hesitant to involve customers or potential customers directly because, from a business perspective, they know people don't want to get involved in these sort of third party disputes, and they don't want to be dragged into other people's litigation.
[00:09:52] Daniella Lee: And so it's also something they're cognizant of because they don't want to dissuade buyers or potential buyers from wanting to purchase whatever product or service the company offers.
[00:10:03] Jim Flynn: Great. Bob, we've, we've talked a little here about discovery. Talk to us about damages. What kind of damages get sought or calculated in these cases?
[00:10:13] Bob Travisano: Sure. So typically it's one of two variations. The agreement could lay out that if the target company upon combination with the acquiring company hits a certain revenue threshold, the seller will get an additional payment of a sum certain. And if it's not a sum certain, it could be some formula that translates to the overall performance of the company.
[00:10:35] Jim Flynn: And that's what we've talked about here as an earnout, right? So there's a performance metric and it either gives them a sum certain, or it says we're going to look at the earnings and we're going to use a formula to figure out how much of that goes to the seller.
[00:10:52] Jim Flynn: Any other kinds of damages or issues that come up in sort of figuring out what these cases are worth?
[00:10:59] Bob Travisano: Well certainly, yeah. A lot of these agreements will also contain prevailing party attorney's fees shifting provisions. So, you know, a company who is weighing whether or not to pursue relief under the agreement along these lines that we're talking about also has to weigh whether or not their case has any strength to it.
[00:11:18] Bob Travisano: Because if it doesn't, they weigh the risk of having to pay their adversary's attorney's fees as well.
[00:11:25] Jim Flynn: We've talked a little about earnouts, and we've heard, you know, some things here about damages and proofs. Let's talk now about indemnification, which has come up a couple times. Bob, what are some examples of why and how indemnification issues arise?
[00:11:42] Bob Travisano: Well let's touch base on what an indemnification situation really is. It's really sort of like a promise to have somebody's back because something should be more the responsibility of one party than the others. So it basically says, I think or don't think that X event is going to happen, but if it does, one party will pay for it.
[00:12:00] Bob Travisano: Again, like an insurance policy. So a lot of merger and sales agreements have warranties and reps and other provisions that tie into indemnification and payment obligations. And typically because people like having the promise to pay, but don't always live up to their word, they add escrow obligations to the agreement as well.
[00:12:20] Bob Travisano: An escrow agreement usually means that some of the purchase price gets held back or is held by a third party for a certain time before being forwarded to the seller. So if there are any seller indemnifications obligations that arise following the closing, there's a pot of money to pay them from.
[00:12:37] Bob Travisano: And at the end of the day, if the period of time passes without any such claims, or if such claims occur and are paid from escrow but there's money left over, the remaining funds get released to the seller.
[00:12:49] Jim Flynn: Got it. Okay. So Daniella, let's follow up on this focus on indemnification and get back to some of the things that you and I each alluded to earlier.
[00:13:01] Jim Flynn: What happens when there's a regulatory investigation that lands on the new entity's desk, but the conduct that the investigation is about dates to before the merger? Explain to us how that plays out in this scenario.
[00:13:17] Daniella Lee: Sure. So these can be really important drivers for ultimate success or failure economically, and that's because these kinds of investigations are very expensive and time consuming, and that's true even if the investigations don't result in any finding of liability.
[00:13:33] Daniella Lee: Typically, step one is that the buyer will send a notice of indemnity claim to the seller consistent with the process set forth in the purchase agreement that will stake their claim. But everything from that point forward becomes very strategic and case specific. So there's often good reason to cooperate between the buyer and the seller in reducing the prospect of liability because the buyer and the seller may want to have that common interest agreement or JDA in place for dealing with the government.
[00:14:00] Daniella Lee: But the extent to which the seller has the right to be involved in the defense can vary dramatically in different purchase agreements. Ultimately, though, the same parties may be at odds over who has responsibility to pay the larger portion of what is hopefully a smaller piece of the pie. It isn't always crystal clear where the line in the sand is for who bears the risk of certain conduct under investigation.
[00:14:24] Daniella Lee: Theoretically and generally, the line in the sand is often the date of the closing. But both sides might have arguments regarding whether certain issues should have or could have been caught during diligence or whether the seller breached certain reps and warranties regarding compliance, and even whether the conduct in question continued after closing and whether that conduct continued because of consistent contributions and involvement of the seller post-closing.
[00:14:49] Daniella Lee: So as you can imagine, there are a lot of different ways that ultimately this can shake out.
[00:14:53] Jim Flynn: Yeah, understood. And it sounds like, at least in the indemnification area, that type of situation would be one that would be prime for litigation or arbitration. Because ultimately parties find it hard to sort of come to an agreement, and may need a third party to assist them.
[00:15:15] Jim Flynn: So, you know, I think that you guys have each given us a good background on the kind of things that can come up post-merger or post-acquisition, both on the earnout side and on the indemnification side. So before I turn over to asking you for some concluding and summary thoughts, I thought we'd have a little bit of fun.
[00:15:39] Jim Flynn: So I mentioned earlier, you know, some books and films and TV shows. I happen to be a big fan of Succession. In fact, you know, a little bit of trivia. One of our partners here, John O'Connor, was an extra in the last episode of Succession when the series ended.
[Clip from Succession]
[00:16:07] Jim Flynn: And it always seems like, to me, that the Roy family got themselves involved in lots and lots of deals with lots and lots of intrigue. And Bob, wondering if any of them stand out to you as something that kind of fits in with the topics we're talking about today.
[00:16:14] Bob Travisano: It absolutely does. But before we get into Succession, wasn't John O'Connor also in The Irishman?
[00:16:18] Jim Flynn: John O'Connor was in The Irishman. It's actually an interesting story about how he developed this little hobby of appearing in pretty highly regarded productions.
[00:16:30] Jim Flynn: But he was in The Irishman, he was in Succession. He was in the Amazing Miss Marple, one of those episodes. So he’s been in a couple of things and we hope to see him in a lot more. What are you thinking about?
[00:16:43] Bob Travisano: So certainly season four of Succession really dealt with the kabuki dance between Waystar Royko, Logan Roy's company, and a company called GoJo. And you know, as we move toward the end of the season in season four, GoJo was about to take over Waystar, and obviously the kids, the Roy kids, putting aside their obvious emotional issues with parting with the family asset, started to delve into the finances of GoJo and found that it had significant structural issues. And it appeared to them that the deal was very shaky. And as they moved through the process, after Roman Roy did his, what he referred to as due diligence, undue diligence, extra diligence, they tried to tank the deal.
[00:17:28] Bob Travisano: So, fictionally, yes, but a clean analogy to fraudulent inducement and post-closing disputes around valuation misrepresentations.
[00:17:37] Jim Flynn: Got it. And do you remember the name of that particular episode?
[00:17:44] Bob Travisano: It was either The Tailgate Party or The Devil's in the Details.
[00:17:49] Jim Flynn: Well, you know, I think each of those are good titles and I've certainly enjoyed tailgate parties from time to time. But I think from a legal perspective, the devil's in the details is kind of a title that lawyers, particularly lawyers, talking about what to do during diligence and then how to avoid post-closing litigation, have to take to heart. So, you know, you can find, and maybe us obsessed lawyers have no option but to find some lessons in what we're watching, supposedly for fun.
[00:18:13] Jim Flynn: For fun. Daniella, can I invite you into my obsession with Succession? Do you have anything you could add on that?
[00:18:21] Daniella Lee: As much as I also love Succession, nothing else from Succession comes to mind, but honestly, sometimes the truth is even stranger than fiction and can be even more interesting and illustrative than fiction anyways.
[00:18:34] Jim Flynn: Elaborate on that. What do you mean by that?
[00:18:36] Daniella Lee: I've had a few of these fights on both sides in the real world, but privilege and propriety prevent me from being able to mention them here or sell them as potential storylines to Succession or Billions or whatever comes next on Netflix or HBO. But the Wall Street Journal did recently do a piece on earnouts, I believe it came out last year, that highlighted a few.
[00:18:57] Daniella Lee: So maybe if we cue the Law and Order music, there's a sort of ripped from the headlines sort of element to those earnout stories in that piece from the Wall Street Journal. I don't know if any of those are headed to litigation, but it would definitely be fun to see.
[00:19:14] Jim Flynn: Interesting. And obviously, you know, for our listeners and viewers, there is a notion that they may be facing issues like this, and while they may not make the headlines, they're certainly important to their businesses and, you know, we obviously are happy to talk to them about, you know, all these kind of issues.
[00:19:34] Jim Flynn: So before we wrap up, I'll give you one last question each. So Bob, if buyers investors, you know, those on that side of transactions, could take one thing away from this podcast, one thing to remember as they look forward to deals and, you know, how to prevail, if there is a post-closing dispute, what would that be?
[00:20:00] Bob Travisano: Sure. So litigators are often called when things go sideways. Involve a litigator in the drafting process. A litigator can help advise on important clauses that will allow a buyer to, in advance, to know what it will look like to enforce its rights later on down the line if there are any issues along the lines of what we've discussed here today, and that focus will typically be on a handful of clauses.
[00:20:22] Bob Travisano: And this isn’t exclusive, but choice of law, so you know what the rules of the game are. Choice of venue, where you'll be enforcing those rules. And ADR clauses, whether you're allowed to mediate or required to mediate if there's arbitration or you go running right into court.
[00:20:38] Jim Flynn: Appreciate that, Bob.
[00:20:39] Jim Flynn: Daniella, I'm going to give you the flip side of that question for our last question. If you're talking to the sellers or potential sellers, what do you tell them as a litigator is the one thing or the most important thing they should be taking away from this podcast as they prepare to sell their business or merge their business into another, so that they can prevail and come out the other side of any post-closure disputes.
[00:21:05] Jim Flynn: What do you tell them?
[00:21:07] Daniella Lee: So I would say to sellers that it makes sense to use some of the leverage that you have in the transaction to negotiate the terms surrounding the indemnification process that's going to be laid out in the purchase agreement. So that includes the amount that's going to be withheld in escrow, how long it's going to be withheld, the deductible, and the cap on the indemnification claims, the length of the indemnity period, and the extent to which you as the seller have the right to be involved in the defense of any claims or government investigations that might come about related to conduct pre-closing, but that might come up after closing. And consulting counsel that's dealt with these sort of post-closing landmines can be instrumental in protecting yourself.
[00:21:47] Daniella Lee: So really to Bob's point, it really makes sense often to get a litigator involved on the front end so that they can help you navigate some of those issues on the front end.
[00:21:56] Jim Flynn: Great. Well, that's all the time we have for today. I want to thank both of you. You were as good at having this conversation as you are in working with me on these kinds of disputes, so I thought that was great for me, certainly, but also for our listeners and viewers.
[00:22:12] Jim Flynn: And to those listeners and viewers, I want to thank you as well. Please subscribe to Speaking of Litigation on YouTube or wherever you get your podcasts.
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No business likes litigation. Lawsuits and trials can be stressful, unpredictable, and often confounding—even for battle-scarred business leaders. But they’re something almost every business must confront. The Speaking of Litigation® video podcast pulls back the curtain for an inside look at the various stages of litigation and the key strategic issues businesses face along the way. Knowledge is power, and this show empowers executives and in-house counsel to make better decisions before, during, and after disputes. Subscribe to Speaking of Litigation® for a steady flow of practical, thought-provoking insights about litigation from Epstein Becker Green litigators.
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