Often, in the business context, agreements contain representations and warranties of the parties to the agreement.  The representations and warranties can range from general items such as business forms and the payment of taxes, to more specific items, such as the accuracy and reliability of financial information.  While such representations and warranties are commonplace in business agreements, their importance should not be overlooked.

Under Pennsylvania law, when performance of a duty under contract is due, any non-performance is a breach.  If a breach constitutes a material failure of performance, the non-breaching party is discharged from its duties under the contract.  A party who has materially breached a contract may not complain if the other party refuses to perform.  In other words, a material breach of contract may excuse performance by the non-performing party.

In the context of representations and warranties contained in a business agreement, should the representations and warranties contained in the agreement prove to be false, the party to whom the representations and warranties were made may raise the falsity of the representations and warranties to excuse further performance of any contractual obligations under the agreement.  Such a circumstance could spell disaster in the business context – particularly in a case where the payment of money is due at some time after closing.

Pennsylvania courts impose an element of materiality to the breach of a representation or warranty.  The elements of materiality under Pennsylvania law include the extent to which an injured party will be deprived of the benefit which he reasonably expected, the extent to which the injured party may be adequately compensated for that part of the benefit of which he will be deprived, the likelihood that the party failing to perform or offer to perform will cure, and the extent to which the party failing to perform comports with the standards of good faith and fair dealing.

Accordingly, representations and warranties contained in an agreement should not be taken lightly, but should be made with any eye toward the potential ramifications in the event of breach.

Two guys are sitting at a bar discussing how they are going to quit their current jobs and start their own business. A lawyer sits next to them, overhears their happy ramblings and pipes in, as lawyers always do, that their mutual promise to devote 100% of their working energy to the new biz has to be reduced to writing. You know this joke, right?

Well, maybe not, and maybe it’s not such a knee slapper anyway. Under Delaware’s Limited Liability Company Act (the “Act”), a person may be admitted to a LLC as a member and may receive a LLC interest without making a contribution or being obligated to make a contribution to the LLC. If an interest in a LLC is to be issued in exchange for cash, tangible or intangible property, services rendered or a promissory note or obligation to contribute one or more of these items, however, the LLC’s operating agreement can and should, identify that obligation. The Act goes further and makes it clear that the operating agreement may provide that a member who fails to perform in accordance with, or to comply with the terms and conditions of, the operating agreement shall be subject to specified penalties or consequences, When a member fails to make any contribution that the member is obligated to make, the operating agreement can provide that such penalty or consequence take the form of reducing or eliminating the defaulting member’s proportionate interest in a LLC, subordinating the member’s interest to that of nondefaulting members, a forfeiture of that interest, or a fixing of the value of his or her interest by appraisal or by formula with a forced redemption or sale of the LLC interest at such value.

If only our clients made it easy on us by letting us write agreements with such detail! A more common scenario is the member who wants us to get rid of the 50% member, formerly a dear buddy, who walked out the door for whatever reason after a few months (or, even worse, walks in and plays on the computer all day doing nothing that needs to be done). Unfortunately, without an operating agreement that clearly identifies expectations with respect to contributions of services and remedies for breach, it is a challenge to argue the defaulting member forfeits his or her interest for failure of consideration as s/he might for failure to “pay” for the interest with cash or property.

While I continue to look out for case law in support of the idea of forfeiture in the context of LLCs, a recent Kansas case did address alternative remedies for breach of obligations with respect to contributions of cash.   In Canyon Creek Development, LLC v Fox, the court struggled with the appropriate remedy available to a LLC when a member failed to satisfy a required capital call. The defaulting member, Fox, argued that he should not be held personally liable for the nonpayment of a post-formation capital contribution where the only remedy set forth in the operating agreement was a reduction of his ownership interest. Interpreting a statute that appears to be similar to the Act, the court ultimately agreed with Fox, making a distinction between the initial contributions (which could be in the form of cash or services, measured by their “net fair market value”) and later capital infusions which had to be in cash (unless the manager otherwise consented). The court concluded that the statutory default rule that a member is obligated to perform any promise to contribute cash or property or perform services, even if a member is unable to perform, supports the proposition that a member may be required, at the option of the LLC, to contribute an amount of cash equal to the agreed value of any initial, unmade, contribution. The court stated this was the law even where the LLC may have other rights against the noncontributing member under the operating agreement or other law. Turning to subsequent capital calls, however, the court found it significant that the remedy of cash damages, the most fundamental remedy for breach of contract, was conspicuously absent from the provisions of the operating agreement. Thus, the court concluded that the failure to include such a fundamental remedy as damages when a member fails to contribute additional capital after the LLC’s initial capitalization was not an oversight, but rather expressed a clear intent that damages are not recoverable from a member who failed to contribute additional capital after the venture was up and running. In the Fox case, the right to reduce the breaching member’s LLC interest was all that the LLC could do to punish the breaching member. No divorce, but better than a non-collectable judgment for a sum certain from my perspective.

It is not uncommon for a minority shareholder to cry foul when the corporation is sold and the shareholder believes he received less than fair value for his shares. Such claims often result in shareholder oppression suits, with the majority shareholder accused of having breached a fiduciary duty to the minority owner. Now it seems that controlling shareholders of even privately held corporations have another potential adversary: the Securities Exchange Commission. The SEC recently sued Stiefel Laboratories and its then-controlling shareholder and CEO Charles Stiefel, alleging that they defrauded current and former employee shareholders out of more than $110 million by buying back shares in the company at undervalued prices prior to the sale of the company to GlaxoSmithKline PLC.

The complaint alleges that the defendants misled the employee shareholders, who had acquired the shares as part of a stock bonus plan, by concealing material information about the potential acquisition of the company by GlaxoSmithKline. Information regarding several offers from private equity firms to acquire stock in the company at a higher price than the valuation provided to employees was also allegedly withheld from employees. The complaint further asserts that the valuation that the company provided to employees was prepared by an unqualified accountant who used flawed methodology. Adding insult to injury, a 35% discount incorporated into the valuation was not disclosed to the employees.

The complaint cites, among other things, the company's repurchase of 800 shares from employees at a price equal to $16,469 per share in the months leading up to the sale to GlaxoSmithKline, which acquired the company for $68,000 per share. As a result of the reduced number of outstanding shares, the remaining shareholders (consisting mostly of Stiefel family members) received a windfall.

The SEC warns that privately held companies and their officers should be aware that federal securities laws are intended to protect all shareholders, regardless of whether they acquire their shares in a private transaction such as a stock bonus plan or on a public market. Corporate officers in corporations with stock bonus plans should take care to obtain appropriate valuations to support stock repurchases from accredited professionals using commonly accepted valuation methodologies. Stock option plans and corresponding summary plan descriptions should be carefully reviewed, with a particular focus on their stock repurchase provisions. All material facts must be fully disclosed to plan participants in a timely manner.

To avoid post-transaction cries of foul play from former shareholders, we often include “tail” provisions that allow the former shareholders to enjoy the same economic benefit of a major company transaction such as a sale or merger that follows the sale of their shares. Such provisions are usually of limited duration (e.g., twelve months). This protects the company and senior management from claims like those raised by Stiefel Laboratories employees after the expiration of the tail period.

Topics deemed “hot” in the context of mergers and acquisitions ebb and flow just as they do in all other aspects of legal study.  When I first started practicing in the early 80s, I remember being taught to carefully include any post transaction covenant not to compete in the sale document as well as in a stand-alone agreement between buyer and seller(s). This seemingly unnecessary duplication of the post transaction obligation imposed on the seller(s) was required to provide multiple legal arguments for enforcing and amortizing the obligation and drive up the aggregate sums payable to the seller(s).  Specific party agreement as to the allocation of the purchase price (and completion of Form 8594 for asset acquisitions) was deemed worthy of considerable negotiation.

Recent Tax Court and First and Ninth Circuit opinions, and this office’s own fourth quarter 2011 transactional work, seem to suggest the elusive covenant not to compete and personal goodwill have again become  important tools for tax planning purposes.  Who owns the goodwill is particularly relevant in the context of hospital purchases of physician practices where the fair market value of hard assets might not be enough to cover malpractice tail insurance let alone justify the physicians’ loss of control over their practice.
 
Under Section 197, certain intangibles must be amortized by the buyer, on a ratable basis, over a 15 year period beginning with the month in which such intangible is acquired. A Section 197 intangible includes “any covenant not to compete…entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof.” But more and more courts refuse to enforce covenants not to compete in the context of the physician- patient relationship, concluding that such covenants are against public policy unless tailored to actually mean only non-solicitation.

Nevertheless, it has been common practice for business lawyers to continue to suggest that each physician in a group practice enter into an employment agreement or other entity document that imposes (or at least tries to impose) a covenant not to compete during and post-employment.  In the absence of such pre-existing non-compete and specific claim to ownership of patient records, however, the selling shareholders and not the entity are arguably possessed of “personal goodwill”, an intangible asset owned by the selling shareholders. To avoid the double tax imposed upon the sale by a C corporation,  maximize the benefits of a meaningful allocation of the purchase price in a sale transaction to intangibles or justify a larger signing bonus, it may be wise to reconsider owner non-compete provisions before the eminence of a sale transaction makes it too late to do so. 

Nobody wants a “Bad Actor” as part of its working group but, from the perspective of  the founder of a startup, the Securities and Exchange Commission’s proposed “bad actor” rules may wind up causing more injury than antidote. The good news is that the SEC is proposing amendments to its rules to implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act to disqualify securities offerings involving certain “felons and other ‘bad actors’” from reliance on the safe harbor from Securities Act registration provided by Rule 506 of Regulation D.  See 17 CFR Parts 230 and 239 (Release No.33-9211; File No. S7-21-11.  I agree with that effort but, since Rule 506 is one of the three exemptive rules for limited and private offerings under Regulation D, and by far the most popular, it is important that the definitions are carefully tailored.  Not all “disqualifying acts” are equal, and “covered persons” and the “bad actor” disqualification should apply only to issuer’s management and controlling equity holders rather than any holder of 10% or more of the entity’s equity.  And, even if those changes are not made, the reasonable investigation standard for determining whether “covered persons” are “bad actors” should be no more onerous than the current standard for accepting money from “accredited investors”. Without these changes to the proposed rules, the process of compliance will be beyond the budget and timeline of most startups. 

We’ve all heard of someone who hit the Enter key too quickly and sent an email he later regretted sending. Unfortunately, in some cases, the result is that the correspondents are deemed to have entered into a contract, without a formal writing and even in the face of evidence that the parties intended to later sign a formal contract. That was the case a few years ago when counsel for Amazon.com sent a one-word reply (“Correct”) to an email from opposing counsel outlining several specific terms of a settlement of a lawsuit. A Pennsylvania court faced a similar case in 2006, when it enforced an unsigned settlement agreement between Commerce Bank and First Union National Bank after concluding that the signing of the agreement was a mere formality since the parties had already evidenced their intent to be bound.