Acquisitions: Some Warranty Considerations

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Acquisitions: Some Warranty Considerations

There are three ways to acquire a company: purchase the business and assets of the company; purchase the stock of the company; and by merger with the company to be acquired, often referred to as the “target.”

The method by which parties choose to accomplish the transaction depends on many factors, not the least of which is tax considerations. An asset purchase has a benefit over a stock purchase or merger in that the buyer assumes only identified liabilities while in a stock purchase or merger the buyer acquires the target with all of its labilities, both known and unknown.¹ On the other hand, an asset purchase is a much more complicated transaction. For example: (i) the transfer of assets and contracts can be a large, complicated undertaking, especially when intellectual property is involved; (ii) sales and transfer taxes must be considered; and bulk sales laws must be consulted.

In any event, regardless of the method chosen to accomplish the transaction, an essential and crucial part of any acquisition agreement is the warranties, and the various methods of accomplishing an acquisition can have different results in respect of the warranties attendant to the transaction.

A. Purchase of Business and Assets vs. Purchase of Stock

In an asset acquisition, the buyer of the assets is the beneficiary of the warranties and, therefore, has a claim based directly on the asset affected by the breach. However, in a stock purchase the beneficiary of the warranties does not become the owner of the assets. The owner of the assets remains the company being acquired, and that company is not the beneficiary of the warranties and, therefore, has no claim because of a breach. Instead the buyer’s injury is indirect: the buyer would have to prove a loss in value of its investment, which would be a more difficult loss to prove. A refinement for buyers to consider is to require the warranties and indemnities to run not only in favor of the buyer but also in favor of the company that is being acquired. A provision to that effect, though, must be accompanied by a clause stating that knowledge by the company being acquired of any matter will not impair any of the warranties in its favor or any of its rights and remedies.

A further refinement would be to merge the company that is being acquired – i.e., the target company – into the buyer or into a subsidiary of the buyer, with the representations of the selling shareholders running directly to the surviving entity. This arrangement results in the warranties having the same effect as those in an asset purchase because the beneficiary of the warranties is the surviving entity which, by virtue of the merger, acquires the assets of the target.

Sometimes a buyer, to avoid the complications of an asset acquisition, will, with seller’s consent, purchase the stock of a company and then liquidate that company under Section 338(h)(10) of the Internal Revenue Code. That section treats the transaction as an asset acquisition, allowing the buyer to get a step-up in the basis of the assets of the company it is acquiring. In this type of transaction, the buyer should consider adding to the contract of sale a provision along the following lines:

Seller acknowledges that Buyer will liquidate the “Target” following completion of the sale. Seller’s representations and warranties and its indemnities will apply – and Buyer will be entitled to enforce them – as if buyer had purchased directly the assets of the Target, not the Target’s stock.

B. Mergers

In the case of a merger in which the shareholders of the participating companies become shareholders of the surviving entity, the result would be the same as an asset acquisition provided the participating companies merge into a new entity, and their shareholders give the warranties to that new, surviving entity, and, if desired, to each other.

If, on the other hand, the surviving entity is one of the companies participating in the merger (as opposed to a newly-formed company into which they are merged) and the participating companies give warranties to one another, then the warranties would be meaningless because in a merger the participating companies become one and the same, resulting in no remedy, since the surviving company would be suing itself.

C. Conclusion

Surely, the effect on the warranties that the method of accomplishing an acquisition has should not be a determining – or even an important – factor in deciding how to accomplish the transaction. The considerations and suggestions discussed above merely provide ways for a buyer, if the buyer so wishes, to alter the effect of warranties in stock acquisitions and mergers.

This article is based on materials found in Transactional Skills – Contract Preparation and Negotiating (Carolina Academic Press, 2019).

1. One liability risk, though, that an asset acquisition does not eliminate, and one which even thorough due diligence might not detect, is a hidden defect in an asset that is being purchased such as a flaw in machinery or software, or in inventory that is purchased for resale. Product liability insurance offers protections against this risk.