HIDDEN LIABILITIES IN MERGERS AND ACQUISITIONS
by Arthur Parry
Increased financial benefits coupled with regulatory restrictions have caused many organizations to merge, acquire or form holding companies, bringing with them new and untested areas of conflict, misunderstanding and potential loss. The importance of such corporate structural change cannot be underestimated. One major area of study is the changing liability resulting from: newly formed corporations; mergers of formerly separate corporations; expansion by a company into different markets, services and activities, and new relationships created by these three changes.
There are four major areas by which to examine a corporate structure undergoing a change, merger or acquisition and certain questions should be asked in each area. These are:
1) The corporation:
- What changes have occurred?
- What is the relationship status of both merged and former organizations?
- What types of entities have been created?
- How do these relate from the standpoint of liability and responsibility over time?
2) Services:
- What new or changed services exist or are contemplated?
- What potential conflicts of interest or opportunities for discrimination exist?
- What new professional liability may exist?
- How has provision been made for continuing audit and control of such new and changing services?
- How do these relate from the standpoint of liability and responsibility over time?
3) Officers and directors:
- What is the status of all former and current officers and directors with respect to changing corporate status, accountability, fiduciary responsibility and protection?
4) Contractual and joint venture undertakings:
- What new and different types of agreements exist?
- How have indemnification, responsibility, agency relationships and hold harmless provisions been identified and addressed?
Corporate Structure
The structure of corporations is rapidly changing and is potentially subject to new laws. It is difficult therefore, to freeze the picture at a point in time with respect to acquisitions, mergers, conglomerate activity, and vertical or horizontal integration.
The complex question of the relationship of the various members of a new organization to other members needs to be examined. The relationship will depend on actual incorporation language and intent, timing of change, and state and federal law involved. If a merger or acquisition is involved, the understandings and agreements with respect to assumptions of liabilities, identification of assets and responsibilities for prior commitments are all important and need to be stated in a precise manner.
If a joint venture is involved, further complications exist. Identification of joint and several liabilities, prior and ongoing hold harmless arrangements or even the dissolution provisions are important.
A conglomerate may establish new corporations which share responsibility with ongoing or phased-out operations.
The most important aspect of this complex change in structure is its effect on the liability and responsibility of individual entities over time. Financial transactions and business are not 'point' occurrences but occur over a period of time and place, often with a change or shift in players. The holding company, in its efforts to move aggressively into more promising areas, may be involved in:
- new states
- new operations
- untried areas
- contractual efforts involving new laws
- non-financial problems
- activities with new partners or joint ventures
- changes in pension plans and overall employee benefits areas
- the merging of workers compensation programs.
The historical liability exposures, attitudes, and protections available will not be equivalent or applicable to new situations. The following situations should illustrate the potential complexity of this area.
Situation 1
A conglomerate purchases and subsequently sells a construction company which has been involved in building municipal stadiums and arenas. After the sale by the conglomerate, a defect is discovered at a prior location-the construction of which occurred before the purchase of the company by the conglomerate. The replacement costs resulting from necessary repairs as a result of the defect will run upwards of $10 million. The risk manager should consider the following questions in trying to evaluate the liability of the conglomerate and the ways in which its insurance program, over time, may or may not have addressed the appropriate protection of such a contingency: What did the conglomerate purchase? What did the conglomerate sell? Are these equivalent? How do you know?
Situation 2
A company acquires two other organizations, each of which has its own pension and employee benefit program. One involves a multi-employer trust, the other a defined benefit program which is significantly 'better' than that of the acquiring company.
The risk manager must evaluate the liability of the acquiring company in attempting to change either of these programs. He should consider the situation involving long-term employees, dependents and retirees. He should also examine such concerns as: the funded status of the plan, dissolution provisions, possible change of benefits, vagueness in plan wording, summary descriptions provided to participants, and rights of employees under ERISA, etc.
New Services and Activities
Many new services are afforded by the changing companies. Several points need to be considered with respect to these new or modified services:
a) they will involve activities for which little or no experience exists currently;
b) as a result of a) there will also be no written procedure or audit trails;
c) such activities may involve new corporations, new relationships and new states so that laws and regulations will not be known or understood;
d) many activities involve new types of professional liability, which will be exacerbated solely by the size and financial strength of the continuing organization;
e) the separation of liability from an ongoing process or series of processes involving different entities of varying size becomes murky at best; and
f) the initiation of such new activity, particularly when acquired corporations or joint ventures are involved, may not have been adequately treated under the acquisition contract or joint venture agreement.
Law with respect to corporations has developed on a state by state basis over time. A brief review of the variety of decisions and verdicts indicates that very little agreement exists among states and, therefore, movement from one state to another will result in new or different approaches under the law.
The following illustration serves to clarify this point and indicate the potential for misunderstanding and disagreement. Today, electronic data processing is a necessity in all major types or organizations. The need for recordkeeping, accounting, reporting and a variety of technical and quantitative methods and controls places heavy dependence on both hardware and software, whether purchased or leased. The question of whether such software is a product or a service varies by state law. One group of states considers software a product requiring legal action under product liability laws. Other states consider software a service requiring 'breach of contract' actions.
With respect to the problem of audits, it should be recognized that neither government examiners nor outside auditors would be able to identify all of the potential problems of changing corporations. Not only is the outside auditor a subject of litigation in many cases but his role is limited to the information provided as well as the relationship which is involved. Further, the auditor today not only has to be knowledgeable in data processing and programming constraints in addition to accounting and financial expertise for each specific type of business, but he will now have to add knowledge of unrelated activities. Thus, the ability of the outside auditor to provide any real measure of protection is severely restricted. This, of course, is compounded as the number of entities involved increases.
Potential Problem Areas
Exhibit A (see end of article) identifies a number of new services or activities which the corporation or holding company may initiate. For each service or activity listed, seven potential problems areas are identified.
Item 8 identifies warehousing with the following potential problem areas:
- lack of security-this would be true of almost any new facility, particularly if items of value are stored;
- lack of written procedures- again, this would be true if no prior experience existed within the organization in warehousing. Because of such lack of procedures, controls would be weak and opportunities for losses or thefts would be higher.
- Personal gain-whenever the potential for personal gain is high and controls are low, a problem exists.
- Pressure for growth-with a new warehouse, like any new facility, costing a significant sum, there will be pressure to 'turn a profit' by uncontrolled growth of revenue resulting possibly in additional problems or losses.
Officers And Directors
This area is very important because it moves from the liability of the corporation to that of a specific individual. It is one thing to discuss the relative responsibilities of corporation A to organization B or manufacturer C to retailer D. It is quite another to talk about the personal liability of John Smith or Henry Jones of the XYZ manufacturing company.
If corporation agreements, understanding, or insurance protections are vague or inadequate with respect to activities of an individual officer or director, then his liability may still exist but the ability to pass it upward to the company is diminished or non-existent.
As corporations are acquired, merged, or created, the point in time each entity change affects the liability status of each individual in that organization. If third party liability protection does not exist or is inadequate, then protection for the individual may have to be secured through corporate indemnification agreements. Unfortunately, many of these agreements are non-obligatory and only potentially available to a specific employee prior to an incident.
An examination of various situations from Exhibit B (see end of article) will illustrate how important changes are in 'creating' or aggravating liability.
For example, if a company has been assured that there may be full assumption of all outstanding liabilities which could include:
a) earlier actions by officers or employees which have resulted in, as yet, undetermined loss;
b) contracts which place the acquiring company in a weakened or exposed position;
c) products manufactured or services performed which, subsequent to the acquisition, result in loss; and
d) self-insured workers compensation without known (non-actuarially estimated) reserves.
In each of these events, individual directors and/or officers of the prior or acquiring company may be brought into a legal action.
Contractual And Joint Venture Undertakings
All corporations need to recognize that hold harmless agreements or joint venture agreements may involve potential loss (not normally assumed to exit) for the following reasons:
1) Joint venture liability is not automatically protected under a primary or excess liability policy.
2) Hold harmless and indemnification agreements are only as good as a) enforceability permitted in the jurisdiction of a suit, and b) the financial guarantees of the indemnitor.
3) Contracts are written from different points of view and with varying levels of professional competence.
4) A current 'deep pocket' theory, by which liability loss settlements are based primarily on ability to pay, will involve the financially sound venture in situations for which it anticipates no responsibility.
5) No legal or judicial requirements exist between primary and excess liability insurers to require cooperation in loss programs.
The corporation, as part of a multiple entity activity should not assume others will address its needs. If the contract identifying the undertaking is obscure or does not adequately reflect the concerns of the institution, the contract should be changed accordingly. With respect to hold harmless agreements, the following are examples of the types of things which should be considered:
- What is the corporation trying to include or exclude?
- Who is to be held harmless? How and why?
- If a purchase, merger or sale of the company is involved, what is being purchased and when?
- Does arbitration exist? Is it clear?
- In what state may suit be brought?
- Is the other party trying to contract away his own negligence?
- May the contract be challenged for impossibility of performance or unequal parties, etc.?
The marketplace is changing rapidly and there are many conflicting forces present in the financial and legal environments. Hopefully, any corporation considering a merger or acquisition will carefully examine the potential for liability and weigh the possible risks that can be wrought by such a change.
EXHIBIT A
Identification of Potential Problem Areas
| | | | Lack of | | | | | |
| | | | Written | | | Conflict | | Pressure |
| | New Service | Lack of | Procd. | Prof. | Discrimi- | of | Personal | for |
| Item | or Activity | Security | &Audit | Liab. | nation | Interest | Gain | Growth |
| 1 | Data Processing | Yes | Yes | Yes |
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