DC Circuit ruling on broker dealers

The D.C. Circuit Court of Appeals today vacated the 2005 Securities and Exchange Commission rule deeming certain broker-dealers not to be investment advisers (17 CFR 275.202(a)(11)-1). The Court held that the Investment Advisers Act, 15 USC § 80b-2(a)(11)(F), does not authorize the SEC to except from the Investment Advisers Act a group that is already covered in another § 80b-2(a)(11) exception. The decision came in Financial Planning Association v. SEC, Case Numbers 04-1242 and 05-1145.

Brown University Venture Forum for Enterprise Slide Deck

I recently spoke at a program on valuation and term sheets at Brown University put on by the Brown Forum for Enterprise. I discussed the topic of valuation issues surrounding stock options and 409A. The slide deck can be viewed here.

Study for West Coast VC Deals in Life Sciences

Fenwick publishes a quarterly study of VC deal activity in various areas. The most recent life sciences report can be found here: http://www.fenwick.com/vctrends/LS_VC_Survey_2006.htm?WT.mc_id=LSVCS_032707_e-mail-corp

Delaware Chancery Court rules on post-closing adjustment dispute

A March decision of the Chancery Court in Matria Healthcare v. Coral SR LLC is an essay on post-closing adjustment (true-up) provisions and the interplay of dispute resolution mechanisms in a purchase agreement.

The case involved a merger between two companies in the disease management and wellness business, Matria and CorSolutions. Apparently, before the closing CorSolutions received some complaints from a key customer about their bill and failed to disclose that to the buyer. Matria got the call from the customer - one day after closing - and then spent the next six months negotiating what turned into a $4 million settlement. This was done without discussion with the seller and without their consent. After the settlement, Matria sought relief from the seller for their payment and the dispute ensued.

To complicate things, this agreement had four different types of dispute and resolution mechanisms, two of which are relevant here. The first was a typical post closing adjustment (true up) provision relating to balance sheet adjustments for things like working capital, cash on hand, indebtedness, etc. Disputes arising from adjustments would be submitted to an outside accountant (a “Settlement Accountant”). These claims were not limited by a cap and would be adjusted on a first dollar basis.

Other claims by the parties relating to the transaction, such those arising from breaches of representations, warranties or covenants, would be handled by a AAA arbitration. These claims would be resolved against a $20 million escrow fund, and were subject to a basket (i.e. deductible) of $4.5 million. The agreement also provided a typical exclusive remedy clause where all claims other than fraud or for injunctive relief would be limited to the escrow fund.

The court noted that, in anticipation of a potential hierarchy issue stemming from the different ADR provisions, the parties also provided that any claim that could be brought related to the financial statement adjustments will be subject to that provision and not subject to the escrow fund. ("The items set forth on or reflected in the [financial statements delivered in connection with the true-up] and any matters relating thereto that could have been subject to adjustment or dispute pursuant to [the true-up] are subject solely to the adjustments set forth in Article II [i.e. by the Settlement Accountant] . . . and accordingly shall not be subject to any claim by [Matria]… on the Escrow Fund.”)

If the claim went before the Settlement Accountant, Matria may recover fully on its $4 million claim; if it goes before the AAA, they will likely get nothing since it will be wiped out by the $4.5 million basket. Therefore, it is not surprising that the parties could not agree on the forum.

The interesting part of this decision is the analysis of how Matria’s claim arising from the customer complaint could be characterized under the agreement. The Court noted that the claim could be (1) a potential claim, serious enough to be reflected on CorSolutions’ balance sheet, and therefore properly before the Settlement Account on a first dollar basis; (2) a misrepresentation based on a failure to disclose and a breach of various representations and warranties and, thus properly before the AAA and subject to the cap and basket ; and (3) a Third-Party Claim pursued by the customer, where yet a third mechanism from indemnity and damage relief would apply. The discussion appears on pp. 15-16 of the decision.

At the end of the day, the court being predominately known for its strict construction, directed the dispute to the Settlement Accountant on the basis of the hierarchy clause that was in the agreement, albeit with some reluctance. (“The result reached here is, in large part, unpalatable; it is the product, however, of words chosen by sophisticated parties who drafted a complex and comprehensive agreement. More importantly, it is not for some judge to substitute his subjective view of what makes sense for the terms accepted by the parties.”).

The moral of the story here is that these are very complex provisions that really need to be tested by the drafters in advance to make sure that they will work in the field. The Matria decision has a lot of other interesting nuggets for transactional lawyers relating to arbitrability, contract constuction and drafting examples (that may or may not work, depending on one's viewpoint) and therefore worth a closer a read.

Federal court rules for Buyer in earnout case

Earnouts are rife with controversy. While they are popular in today’s deal market, and most parties see them as a creative remedy to bridge a pricing or funding gap, the majority fail and result in disputes. Assuming the best of intentions to honor the original agreement, it is impossible to predict all of the parameters that may impact a future earnout potential. A recent decision by the US District Court for E.D. of Wisconsin, Didion Milling, Inc. v. Agro Distribution, LLC (2007 WL 702808) is a good primer of some the issues that may need to be tested at the purchase agreement stage.

The earnout here was based on a net cash flow determination, where the APA provided a list of guidelines on how it would be calculated, including a reference that GAAP would be used. Despite a provision in the APA that the agreement could not be assigned, the buyer assigned the agreement to another entity, which in turn assigned it again, so that the party owing the earnout was not the original buyer. Since the earnout was based on a calculation of the original business acquired, this complicated the earnout calculation not to seller’s liking.

One issue was that net cash flow was supposed to take into account after-tax numbers. The original buyer was a corporation, so it paid its own taxes. The ultimate successor was an LLC, a pass-thru, so the tax rates and rules would be different, and would not be paid by the business but by its members. This created ambiguity as to whether taxes should be included, and if so, how much. This is probably something that, now with 20-20 hindsight, should be addressed specifically in the purchase agreement.

The parties disagreed as to the interest deduction against the earnout calculation, and whether the buyer’s overall cost of capital can be used to apply across the board. Again, probably something that can be spelled out in advance, at least by plugging in numbers for min/max.

Finally, this case also involves a claim for good faith and fair dealing, which is common in earnout cases. To provide the flavor what is usually alleged, the plaintiffs claimed that each of the following was a separate reason to find bad faith: (1) buyer acquired the business aware that seller had not consented to the assignment; (2) buyer focused on reselling the business rather than operating it; (3) buyer failed to provide seller with monthly financial statements; (4) buyer failed to provide seller with the documentation necessary to support calculation of net cash flow; and (5) buyer engaged in “sharp dealing” by assessing taxes, charging interest, and early expensing of payment. The court rejected all of these as a matter of law.

A couple of these deserve comment. On the consent issue, the court noted that while a good faith claim did not work here because the ultimate buyer had no privity with the seller under the original seller, there could be a claim for intentional interefence with a contract (which was not alleged here).

On “sharp dealing”, the court explained that a party may violate the duty of good faith by taking deliberate advantage of another party’s oversight. Such sharp dealing may or may not be actionable in tort. Actions such as avoiding an unbargained for expense or obtaining an advantage by way of exploiting superior knowledge do not, however, constitute sharp dealing or a breach of the duty of good faith.

ACG Boston DealMaker Blog

For those interested in a mix of deals in both private equity and venture capital, ACG Boston's DealMaker site is a great spot to learn about new deals and happenings in the Boston high-tech and investment market.

Second Circuit rules that auditors have duty to correct past opinions

A recent ruling against a small accounting firm by the Second Circuit Court of Appeals may have broad implications for the accounting industry. In Overton v. Todman & Co., investors in a privately-held company brought an action for securities fraud under Section 10b-5 against the company's auditor. They alleged that the financial statements were wrong and the auditor's opinion that the statements were correct was false when made. While New York Southern District dismissed the case, the Second Circuit appeals court reversed the decision, holding that the auditor may be held primarily liable for federal securities fraud.

Specifically, the Court held that an accountant has a “duty to correct” the opinions and statements that it issues and violates that duty and becomes primarily liable for securities fraud when it:

(1) makes a statement in its certified opinion that is false or misleading when made;
(2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading;
(3) knows or should know that potential investors are relying on the opinion and
financial statements; yet
(4) fails to take reasonable steps to correct or withdraw its opinion
and/or the financial statements; and
(5) all the other requirements for liability [for securities fraud] are satisfied.

The court also noted that accountants can also be held primarily liable if they assume the role of an insider in the company. ("[I]f the accountant exchanges his or her role for a role as an insider who vends the company’s securities, then the accountant shares in an insider’s duty to disclose.")

The Court attempted to limit the impact of this decision by holding that the duty to correct was not implying that theere was a duty to update its past opinions. ("The duty to correct requires only that the accountant correct statements that were false when made. In contrast, the duty to update requires an accountant to correct a statement made misleading by intervening events, even if the statement was true when made. ") Immediately following that statement, however, the Court cited a case for the proposition that "in limited circumstances, an issuer may have 'a duty to update opinions and projections . . . if the original opinions or projections have become misleading as the result of intervening events'").

While the allegations in this case are a bit extreme, this case may have wide-reaching potential to create a new level of hedging (and CYA memos and disclaimers) for the accounting industry. The court's mere hinting that there could be situations where an auditor could be held liable where it knew or should have known about an issue that needed updating places both accountants and young companies they represent in a tough spot. The decision suggests that accountants are only liable if they make a statement (i.e. issue an audit opinion), which is a sine qua non for many companies in raising their first and following venture round. Accountants (like lawyers) also often play a significant role in the business of a young or small company, i.e. act as insiders, and this case suggests that liability awaits. I guess no good deed goes unpunished! If other courts follow, both accountants and lawyers may really need to limit their role as company business advisors for mitigate potential exposure to these types of claims.

Indemnification rights in venture deals

While the venture market still seems flush with cash, a number of recent litigations involving venture firms (such as the Hummer Winblad case now in seemingly constant discussion) are driving the market to seek additional protections from their portfolio companies upon investment and afterwards.

In particular, some investors are now asking for indemnification from the company akin to the measures in an acquisition agreement. Companies looking to oppose these provisions should know that they are generally rare. While an indemnity is market where the deal presents some liquidity to the founders or other investors. this is not common in the venture context. The VC investors typically have board seats, observation and information rights and strong covenants, so they are in a position to see how the money is spent. If they don't have then, this presents a bargaining chip for the company in exchange for the indemnity being sought. They also have the right to sue the company for breach of the reps or fraud while there is still money to pay the claim. Unlike an M&A deal, venture round docs usually don't have exclusive remedy clauses.

A later stage financing certainly is more likely to give concern to the investor about the unknown that cannot adequately be tested through due diligence, but it would be unfair to shift that risk to the founders. If I am a VC asking for this provision and getting it regularly, I have to ask kind of company (and founder team) am I investing in if they will accept those terms. The
better the terms for the VC, the more apparently becomes the adverse selection problem.

One way to deal with the issue is to ask the investors their specific concerns. If there is a known problem, such as a litigation, a 409A problem, etc., that can be dealt with through traunches, escrow etc, without personally impinging on the Founders . The NVCA model docs address this issue parenthetically by having certain reps be made by the Founders, where the "Founder's liability for breaches of any provisions of this Section 3 shall be limited to the then current fair market value [as determined in good faith by the board of directors of the Company and such Founder [may, in his sole discretion, discharge such liability by the surrender of such shares or the payment of cash] (note FN1 and FN2 below from the docs). The NVCA docs are intended as a fair starting point for a Series A round, and they do not contemplate an indemnity. Finally, another approach may be to allow the indemnity, but to limit all recourse to the Founder's shares. The risk here, of course, is the precedent for the next round.


[1] Founders' representations are controversial and may elicit significant resistance. They are more common in the Northeast and counsel should be warned that they may not be well received elsewhere.
They are more likely to appear if Founders are receiving liquidity from the transaction or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution
or the Founder was formerly with another Company whose business could be deemed competitive with the Company). Founders' representations are not common in subsequent rounds, even in the Northeast, where risk is viewed as significantly diminished and fairly shared by the investors rather than being disproportionately borne by the Founders.

[2] Investors should consider whether cash is an acceptable remedy; the cash value of the shares is likely to be low, particularly if there has been a breach of a rep or warranty. In addition, if the Investors require the surrender of shares rather than cash, they should also consider whether to include Preferred Stock, as well, if the Founder owns shares of Preferred.