Litigation Traps in Purchasing a Business

The purchaser may not be able to preserve the value of the information acquired. Nominal trade secret information may become known to 'other persons' in numerous ways, including:

• non-existent/inadequate trade secret agreements between the seller and its employees past and present;
• disclosure by the seller to other potential purchasers with non-existent/inadequate or unretained documentation of confidentiality agreements;
• protective orders in past trade secret litigations; or even
• where the seller may have acquired the trade secret from a predecessor with an inadequate/non-existent trade secret agreement.

The UTSA recognizes a cause of action for misappropriation and misuse of trade secrets where a trade secret is found to exist and the acquisition, disclosure or use of that secret by another was 'improper.' The existence of the trade secret turns on the value to the owner from the fact that the information is not known by others and the extent to which the owner has taken appropriate steps to keep that information unknown to others.

Claims By Unsuccessful Purchasers Of Interference

Purchasers should be mindful of claims by unsuccessful purchasers of interference. Generally, such claims derive from two fact patterns. In the first, the purchaser may be accused of the tort of inducing breach of contract between the unsuccessful suitor and the seller. Proof of that cause of action requires the existence of a valid and enforceable contract (between the suitor and the seller), the defendant's knowledge of the contract and intent to induce its breach, breach of the contract by the seller and that the breach was caused by defendant's wrongful and unjustified conduct.

In California, for example, an action for inducing breach of contract cannot be defeated simply because the contract breached was terminable at will, since it is the will of the parties only, and not at the will of another. Since the act of inducing the breach must be intentional, a defendant who did not know that a contract existed or who had no intention of inducing a breach cannot be held liable even if an actual breach results from that defendant's improper act. However, that the defendant intended to interfere with a specific contractual relationship is actionable even if the defendant did not know the unsuccessful purchaser's name or identity.

The second fact pattern is based upon the cause of action of intentional interference with perspective advantage. The elements are the existence of a prospective economic relationship with the probability of future economic benefits to the plaintiff (unsuccessful purchaser); the defendant's knowledge of the relationship and intent to disrupt it; actual disruption of the relationship; that defendant's interference was wrongful by some measure beyond the fact of the interference itself; disruption caused by the defendant's conduct; and damages suffered by the plaintiff. The tort of interference with the prospective economic advantage is not dependent on the existence of a contract. The actionable wrong lies in the disruption of the relationship itself. Further, only persons who are not parties to the purported prospective economic relationship can be held liable for interference with that advantage.

In California, the classic case concerning interference with perspective economic advantage in the sale of business contacts involved a perspective seller/supplier whose perspective purchaser (ultimately unsuccessful) who as part of its due diligence contacted the supplier's major customer. The major customer told the ultimately unsuccessful purchaser that if the supplier sold its business that the customer would exercise its right to terminate its contract with the supplier. The customer's statements were made solely to frustrate the proposed sale so that the customer could purchase the business for a fraction of the original price.

Inadequate Covenants Not To Compete

Almost all purchasers are savvy enough that they require that the seller sign a covenant not to compete. Covenants not to compete are generally part of any purchase and sell agreement. Laws concerning covenants not to compete differ in various jurisdictions. Unresolved conflict of law issues remain concerning validity and enforceability. In jurisdictions where policy disfavors covenants not to compete, validity may require that the covenant be obtained in connection with and from one who sells all of his interest, shares and good will of a business.

In jurisdictions less disapproving of such covenants, validity may extend to former employees. Whatever the jurisdiction, the purchaser should take appropriate steps to obtain covenants not to compete from the seller with appropriate language describing the seller as including all those acting in concert or in association with the seller. Careful consideration should be given as to how the purchaser can protect against competition from others such as non-owner family members involved in the acquired business and key employees not subject to the covenant who pose a risk of competition. In such situations, at a minimum, the purchaser should ascertain whether those non-owners are bound by valid and enforceable trade secret and non-solicitation agreements. If there are those against whom the covenant would be invalid or unenforceable and those persons are not bound by trade secret and non-solicitation agreements, it may not be advisable to proceed with the purchase.

Overbroad Representations, Warranties and Covenants

Generally, more attention is directed at the seller's representations, warranties and covenants. However, purchasers should take care that the 'standard representation and warranties' are not so overbroad as to interfere with business operations or give rise to liability. Standard representations and warranties collectively might establish a basis for the seller to assert an obligation that the buyer shall not take any action that might unreasonably deny the seller the benefit of the bargain. That, when coupled with a covenant of good faith and fair dealing that may be implied in business contracts, may give rise to litigation, especially in the context of an earn-out provision in the purchase price and/or a seller's consulting agreement.

In the absence of specific provisions disclaiming any obligation of the purchaser to operate other than pursuant to its own standard practice and procedure, dissatisfied sellers have initiated litigation against purchasers alleging all types of 'unreasonable conduct' in violation of the 'implied covenant of good faith and fair dealing,' which the seller claims negatively impacted the seller's earn-out, and allegedly could have been avoided if the seller/consultant 'had been allowed to take a more active role.'

Similarly, dissatisfied sellers have taken it further, such as claiming that the purchase price/earn-out was based upon schedules, budgets and business plans that were exchanged, none of those plans were adhered to and subsequent events prove that upper management was aware or considering drastic revisions to those plans, but that had not been communicated to the purchaser's acquisition team. The seller then asserts breach of contract based upon generalized representations and warranties and inadequate disclaimers and claims fraud in the inducement, concealment and suppression of facts. Purchasers should take care that the representations and warranties are not so overbroad that the seller may 'hang his litigation hat' on an implied covenant of good faith and fair dealing.

Inadvertent Implied Assumption Of Seller's Obligations In An Asset Purchase

A key advantage in an asset purchase is that the purchaser does not assume the seller's liabilities. When the purchaser acquires all of the selling corporation's assets, the question may arise whether the purchaser has also assumed the seller's liabilities by operation of law or otherwise. Generally, a purchaser is not liable for the seller's liabilities in the absence of an agreement to assume such liabilities.

There are exceptions to the general rule of non-liability ' such as the successor liability doctrine applicable to products liability ' and transactions where the consideration paid for the seller's assets is the purchaser's stock only and the purchaser continues in the seller's business with the seller's shareholders becoming shareholders of the purchaser and the seller corporation liquidating. There is a less well-known third exception of implied assumption of contract. Such an implied contract may be found in the absence of a writing, where all elements of a binding contractual relationship are reflected by the party's conduct.

Thus, even though a promise may not be stated orally or in writing, the promise for a contract may be inferred in whole or in part from the party's conduct, and the purchaser may be estopped from denying the implied contractual obligation. Such a contract may be implied where the purchaser is aware of the contract that the seller had with a third party and after the purchase and sell continues to do business with the third party accepting the benefits of the seller's contract. These exceptions are threats to the very protection purchasers seek in purchase and asset sale agreements.

Assuming Liabilities Of The Seller Without Benefit Of Corresponding Insurance Coverage

Purchasers should take care that the purchase and sale documents specifically address the issue of insurance ' that the insurance specifically provides for assignment of insurance benefits to the purchaser and that the insurer consents in writing to the assignment prior to the consummation of the purchase and sale.

The California Supreme Court recently ruled, in a toxic tort case, that the transfer of assets and liabilities from one corporation to another does not automatically include insurance coverage. The Court sided with insurers holding that the 'operation of law' doctrine did not entitle a corporation that purchased the assets of a chemical manufacturer to an indemnification from an insurer to cover damages for injuries that predated the purchase. The Court concluded that since the purchaser was not the policyholder, the purchaser did not qualify for insurance benefits to cover the cost of settling toxic tort suits filed by employees.

Gary A. Wexler is a partner with Reish Luftman McDaniel Reicher in Los Angeles where he focuses on litigation resulting from the purchase and sale of businesses. He can be reached through the firm's Web site at http://www.reish.com/.

When prospective purchasers of businesses don't perform a thorough due diligence on the sellers, the result can be unneeded and protracted litigation. Due diligence should include investigation into trade secrets, other potential purchasers, covenants not to compete, seller's liabilities and insurance coverage. The purchaser should consider all 'what ifs' including claims and remedies during the due diligence period. What if the seller defaults? What if the seller breaches the representations and warranties? What if the seller violates the covenant not to compete? What if the seller discloses or has already disclosed to others acquired trade secret information? Paying too much too early to a seller without substantial assets or sufficient holdbacks are red flags. In the event of a seller's breach and purchaser's lawsuit, any resulting judgment may be uncollectible.

Purchasing Trade Secrets That Were Not Adequately Protected

The Uniform Trade Secret Act (UTSA) defines 'trade secret' as information that derives independent economic value, actual or potential, from not being generally known to the public or other persons who can obtain economic value from its disclosure or use, and is the subject of efforts that are reasonable under the circumstances to maintain its secrecy. The purchaser's due diligence should include an analysis of the seller's trade secrets. If those trade secrets are generally known to the public or, more likely, known to other persons who can obtain economic value from disclosure or use, or not the subject of efforts that are reasonable under the circumstances to maintain secrecy, trade secret protection will not be afforded in the event of misappropriation.

The purchaser may not be able to preserve the value of the information acquired. Nominal trade secret information may become known to 'other persons' in numerous ways, including:

• non-existent/inadequate trade secret agreements between the seller and its employees past and present;
• disclosure by the seller to other potential purchasers with non-existent/inadequate or unretained documentation of confidentiality agreements;
• protective orders in past trade secret litigations; or even
• where the seller may have acquired the trade secret from a predecessor with an inadequate/non-existent trade secret agreement.

The UTSA recognizes a cause of action for misappropriation and misuse of trade secrets where a trade secret is found to exist and the acquisition, disclosure or use of that secret by another was 'improper.' The existence of the trade secret turns on the value to the owner from the fact that the information is not known by others and the extent to which the owner has taken appropriate steps to keep that information unknown to others.

Claims By Unsuccessful Purchasers Of Interference

Purchasers should be mindful of claims by unsuccessful purchasers of interference. Generally, such claims derive from two fact patterns. In the first, the purchaser may be accused of the tort of inducing breach of contract between the unsuccessful suitor and the seller. Proof of that cause of action requires the existence of a valid and enforceable contract (between the suitor and the seller), the defendant's knowledge of the contract and intent to induce its breach, breach of the contract by the seller and that the breach was caused by defendant's wrongful and unjustified conduct.

In California, for example, an action for inducing breach of contract cannot be defeated simply because the contract breached was terminable at will, since it is the will of the parties only, and not at the will of another. Since the act of inducing the breach must be intentional, a defendant who did not know that a contract existed or who had no intention of inducing a breach cannot be held liable even if an actual breach results from that defendant's improper act. However, that the defendant intended to interfere with a specific contractual relationship is actionable even if the defendant did not know the unsuccessful purchaser's name or identity.

The second fact pattern is based upon the cause of action of intentional interference with perspective advantage. The elements are the existence of a prospective economic relationship with the probability of future economic benefits to the plaintiff (unsuccessful purchaser); the defendant's knowledge of the relationship and intent to disrupt it; actual disruption of the relationship; that defendant's interference was wrongful by some measure beyond the fact of the interference itself; disruption caused by the defendant's conduct; and damages suffered by the plaintiff. The tort of interference with the prospective economic advantage is not dependent on the existence of a contract. The actionable wrong lies in the disruption of the relationship itself. Further, only persons who are not parties to the purported prospective economic relationship can be held liable for interference with that advantage.

In California, the classic case concerning interference with perspective economic advantage in the sale of business contacts involved a perspective seller/supplier whose perspective purchaser (ultimately unsuccessful) who as part of its due diligence contacted the supplier's major customer. The major customer told the ultimately unsuccessful purchaser that if the supplier sold its business that the customer would exercise its right to terminate its contract with the supplier. The customer's statements were made solely to frustrate the proposed sale so that the customer could purchase the business for a fraction of the original price.

Inadequate Covenants Not To Compete

Almost all purchasers are savvy enough that they require that the seller sign a covenant not to compete. Covenants not to compete are generally part of any purchase and sell agreement. Laws concerning covenants not to compete differ in various jurisdictions. Unresolved conflict of law issues remain concerning validity and enforceability. In jurisdictions where policy disfavors covenants not to compete, validity may require that the covenant be obtained in connection with and from one who sells all of his interest, shares and good will of a business.

In jurisdictions less disapproving of such covenants, validity may extend to former employees. Whatever the jurisdiction, the purchaser should take appropriate steps to obtain covenants not to compete from the seller with appropriate language describing the seller as including all those acting in concert or in association with the seller. Careful consideration should be given as to how the purchaser can protect against competition from others such as non-owner family members involved in the acquired business and key employees not subject to the covenant who pose a risk of competition. In such situations, at a minimum, the purchaser should ascertain whether those non-owners are bound by valid and enforceable trade secret and non-solicitation agreements. If there are those against whom the covenant would be invalid or unenforceable and those persons are not bound by trade secret and non-solicitation agreements, it may not be advisable to proceed with the purchase.

Overbroad Representations, Warranties and Covenants

Generally, more attention is directed at the seller's representations, warranties and covenants. However, purchasers should take care that the 'standard representation and warranties' are not so overbroad as to interfere with business operations or give rise to liability. Standard representations and warranties collectively might establish a basis for the seller to assert an obligation that the buyer shall not take any action that might unreasonably deny the seller the benefit of the bargain. That, when coupled with a covenant of good faith and fair dealing that may be implied in business contracts, may give rise to litigation, especially in the context of an earn-out provision in the purchase price and/or a seller's consulting agreement.

In the absence of specific provisions disclaiming any obligation of the purchaser to operate other than pursuant to its own standard practice and procedure, dissatisfied sellers have initiated litigation against purchasers alleging all types of 'unreasonable conduct' in violation of the 'implied covenant of good faith and fair dealing,' which the seller claims negatively impacted the seller's earn-out, and allegedly could have been avoided if the seller/consultant 'had been allowed to take a more active role.'

Similarly, dissatisfied sellers have taken it further, such as claiming that the purchase price/earn-out was based upon schedules, budgets and business plans that were exchanged, none of those plans were adhered to and subsequent events prove that upper management was aware or considering drastic revisions to those plans, but that had not been communicated to the purchaser's acquisition team. The seller then asserts breach of contract based upon generalized representations and warranties and inadequate disclaimers and claims fraud in the inducement, concealment and suppression of facts. Purchasers should take care that the representations and warranties are not so overbroad that the seller may 'hang his litigation hat' on an implied covenant of good faith and fair dealing.

Inadvertent Implied Assumption Of Seller's Obligations In An Asset Purchase

A key advantage in an asset purchase is that the purchaser does not assume the seller's liabilities. When the purchaser acquires all of the selling corporation's assets, the question may arise whether the purchaser has also assumed the seller's liabilities by operation of law or otherwise. Generally, a purchaser is not liable for the seller's liabilities in the absence of an agreement to assume such liabilities.

There are exceptions to the general rule of non-liability ' such as the successor liability doctrine applicable to products liability ' and transactions where the consideration paid for the seller's assets is the purchaser's stock only and the purchaser continues in the seller's business with the seller's shareholders becoming shareholders of the purchaser and the seller corporation liquidating. There is a less well-known third exception of implied assumption of contract. Such an implied contract may be found in the absence of a writing, where all elements of a binding contractual relationship are reflected by the party's conduct.

Thus, even though a promise may not be stated orally or in writing, the promise for a contract may be inferred in whole or in part from the party's conduct, and the purchaser may be estopped from denying the implied contractual obligation. Such a contract may be implied where the purchaser is aware of the contract that the seller had with a third party and after the purchase and sell continues to do business with the third party accepting the benefits of the seller's contract. These exceptions are threats to the very protection purchasers seek in purchase and asset sale agreements.

Assuming Liabilities Of The Seller Without Benefit Of Corresponding Insurance Coverage

Purchasers should take care that the purchase and sale documents specifically address the issue of insurance ' that the insurance specifically provides for assignment of insurance benefits to the purchaser and that the insurer consents in writing to the assignment prior to the consummation of the purchase and sale.

The California Supreme Court recently ruled, in a toxic tort case, that the transfer of assets and liabilities from one corporation to another does not automatically include insurance coverage. The Court sided with insurers holding that the 'operation of law' doctrine did not entitle a corporation that purchased the assets of a chemical manufacturer to an indemnification from an insurer to cover damages for injuries that predated the purchase. The Court concluded that since the purchaser was not the policyholder, the purchaser did not qualify for insurance benefits to cover the cost of settling toxic tort suits filed by employees.

Gary A. Wexler is a partner with Reish Luftman McDaniel Reicher in Los Angeles where he focuses on litigation resulting from the purchase and sale of businesses. He can be reached through the firm's Web site at http://www.reish.com/.