Managing Risk and Liability in the Sale of a Business

By Ted Offit and Jesse Delanoy

INTRODUCTION

For a business owner, the sale of a business typically represents a significant lifechange, from many perspectives. The seller is no longer the owner, the boss. Even though, as is often the case, the seller may continue to work at the company for some period of time, the seller has placed ultimate control over the business’s destiny in the hands of others. The level of responsibility changes; often the pressure is much less. The interest in profitability may change, and the seller’s personal incentive to grow the business may be drastically different. And, ironically, although the seller may feel relieved from exposure to the risks and vagaries of owning and operating a business, the seller’s actual exposure may, in some ways, have increased as a result of the sale.

When a business is sold, it is customary for the seller to make certain promises (known as “representations and warranties”) to the buyer regarding the condition of every facet of the business. The accuracy of financial statements, the seller’s title to the business assets, compliance with tax and regulatory requirements, the enforceability of contracts, matters concerning the company’s workers and many other matters are usually the subject of the seller’s representations and warranties. The seller also in many instances agrees to indemnify the buyer against loss arising from any existing debt or obligation of the business not expressly assumed by the buyer with regard to the seller’s previous operation of the business prior to closing. Prior to the business sale, many or most of the problems which might arise in these areas would result in liability by the company, but not in personal liability by the owner because the company and not the owner would be responsible for satisfying the debts and paying the claims of the company. But once the business is sold, the seller must usually compensate the buyer for certain losses suffered by the purchased business due to indemnification promises by individual sellers in connection with the sale, the pre-existing debts or the inaccuracy of any of the representations and warranties, whether intentional or accidental. The protection from personal liability which the seller once enjoyed, from the use of a business entity such as a corporation or limited liability company, is gone, and the seller’s personal assets, including the purchase price received on the sale of the business, and potentially much more, are at risk.

PROTECTION

The seller, though, has a variety of options available in order to minimize and to protect against the financial harm caused by such personal exposure. These options include the use of:
• non-recourse contracts;
• liability caps;
• indemnity baskets;
• representation and warranty insurance;
• retitling assets; and
• asset protection trusts
Since the circumstances surrounding each sale of a business are unique, the seller should carefully consider which of these options may be appropriate fo r the transaction.

Non-recourse Contract

In a non-recourse contract, the seller neither makes any representations and warranties regarding the condition of the company, nor agrees to indemnify the purchaser for existing liabilities. In essence, the buyer is purchasing the company “as is,” and so assumes all the risks of undiscovered liabilities which may arise after closing. Since the buyer is taking all the risks in a non-recourse contract, the purchase price which the seller receives will generally be less than if the contract provided the basic protections of representations, warranties and indemnifications to the buyer.

Caps on Liability

Even with a buyer who insists that the seller warrant the condition of the business and indemnify the buyer for claims and losses, the seller can still retain a measure of protection against undiscovered liabilities, with the buyer’s recourse limited to a certain “cap” amount. The cap on such recourse is often limited to a negotiated portion of the purchase price. Since the buyer could likely recover more from the seller if there were no cap on liability, the buyer will often require that some or all of the purchase price be placed in escrow, possibly for several years, so that there is an available source of money from which to satisfy claims by the buyer. At the end of the escrow term, the deposit, or any amount remaining after satisfaction of buyer claims, will be paid out to the seller, as part of the purchase price for the business. However, during the term of the escrow, neither the buyer nor the seller will have control of the deposit.

Indemnity Baskets

The use of an indemnity basket recognizes that in the sale of any business, especially in larger transactions, there will certainly be some claims or charges against the business in the buyer’s hands which were existing debts prior to the sale, or which arise from breaches in the seller’s representations and warranties. The basket provides that the buyer may not recover any compensation from the seller unless and until the aggregate of such claims against the business exceed a certain fixed amount, agreed to in the contract. The seller can offer the buyer two types of an indemnity basket: an excess liability basket, or an overflow or dollar o ne basket.

An excess liability basket provides that the buyer may recover from the seller for ndemnification and for breaches of representations and warranties only to the extent that the aggregate of such claims exceeds the agreed amount. For example, if the agreed basket amount were $50,000, then the buyer would have no right to recover from the seller the first $50,000 in claims against the business, costs and expenses subject to the seller’s indemnity. Only when the total of such claims, costs and expenses exceeds $50,000 would the buyer be able to sue for and collect from the seller the amount of claims, costs and expenses incurred over and above this amount.

In contrast, an overflow basket would entitle the buyer to collect the first $50,000 of claims, costs and expenses, in addition to the excess, from the seller, but only after the
aggregate amount exceeds the $50,000 base. If the total amount of claims, costs and expenses were to top out below $50,000, the buyer would have no recourse against the seller.

Representation and Warranty Insurance

An alternative to the contract protections for the seller described above is a recent insurance product known as representation and warranty insurance. Representation and warranty insurance is transaction specific, in that it covers only those representations and warranties made by the seller in a specific transaction, and can thereby be used to protect the seller from the financial harm caused by the unintentional breach of certain representations and warranties. Such insurance also covers existing claims against the company, and so, can supplement or even replace the need for an escrow deposit or an indemnification basket.

Before using representation and warranty insurance, a seller should consider such factors as coverage protections, amounts and restrictions, premium amounts, qualification as a tax deductible expense, events of policy termination and coverage of indemnification claims.

However, there are some drawbacks to the use of representation and warranty insurance. Actual knowledge of facts or circumstances by the seller prior to closing that would reasonably be expected to give rise to a breach or claim will result in exclusion from coverage. Also, since the insurer provides coverage for specific representations and warranties of the seller, the underwriting process will require a second level of due diligence that may be quite time-consuming and expensive and thus, may result in the delay or even disruption of the sale of the business.

Retitling Assets

Another strategy that the seller may consider to protect personal assets from claims by the buyer, is to retitle many or all of the seller’s personal assets, either by placing the assets in the seller’s spouse’s individual name, or in the joint name of the seller and seller’s spouse, as tenants by the entireties. The effect of retitling assets in this way is that the seller will gain the protection of marital laws which prevent creditors of one spouse from reaching and seizing assets held by the other spouse, or assets held in joint name. Thus, in the event that the buyer sues the seller for breach or indemnification, the buyer will be able to collect only out of assets held in the seller’s individual name. It must be noted, however, that retitling assets in this way will not protect the seller if done with the intention to avoid a known or existing claim by the buyer, since such an action would be considered fraudulent. A wise approach would be to retitle assets well in advance of the sale of the business, in order to minimize the possibility of a fraud claim against the seller arising from transfers of the seller’s assets at or around the time of the sale.
In addition, a seller contemplating transferring assets into a spouse’s name should first consider the estate and gift tax consequences of retitling the assets. Placing the bulk of the family’s assets in one spouse’s individual name, or in joint name, may have a significant adverse impact upon the family’s ability to minimize its overall estate tax liability through use of the unlimited marital deduction, each spouse’s lifetime estate and gift tax exemption amount, and the annual gift exemption amounts. Depending upon the wealth of the seller, the need for efficient estate planning may take precedence over the optimum protection against contingent liabilities.

Furthermore, the transfer of assets into the spouse’s name may have a material effect upon the seller’s right to the assets in the event of a marital separation. Depending upon whose name the assets are retitled in, the seller may be at a material disadvantage during a marital separation proceeding. Thus, the same marital laws which ordinarily protect the seller from creditors may in fact work against the seller in a separation or divorce.

Asset Protection Trusts

The final strategy presented herein for protecting the seller’s assets from claims by the buyer, as well as from other creditors, is the use of an offshore asset protection trust (“APT”). An APT operates like any other trust in which distributions of income or assets to the beneficiaries are made only at the discretion of the trustee. However, unlike most estate planning trusts, the APT will be governed by the laws of a foreign jurisdiction which has favorable asset protection laws. The effect of establishing an APT is to place upon a creditor the burden of meeting certain prohibitive legal procedures and requirements of the foreign jurisdiction before the creditor can seize the assets of the APT. Meeting such requirements can be time-consuming, complicated and expensive, and may therefore deter many creditors from filing suit to seize the assets of the APT, or at least may provide the trust beneficiary (in this case, the seller) with leverage to negotiate a favorable settlement.

The typical APT would give the seller control of the assets until a substantial claim or crisis arises, at which time control of the assets would automatically revert to the trustee. Thus, in order to secure protection of the assets in an APT, the seller must be willing to eventually sacrifice total control of the assets. Since the needs of each seller are unique, a seller should consult with an attorney in designing an APT which will provide an appropriate balance for protection and control of the assets.

Conclusion

In any business transaction, unanticipated and undiscovered liabilities will arise after closing which may cause financial harm and loss to the seller. Such liabilities may result from the seller’s unintentional breach of representations and warranties or from existing claims against the company. Without adequate protection, the seller stands to lose the purchase price, and possibly more. It is therefore advisable for a seller to prepare for such exposure by seeking appropriate protections. The seller has many options available, including traditional protections and alternative aggressive strategies, in order to minimize the risk of financial loss. Since the risks and liabilities in each transaction are different, a seller should carefully consider which strategy or strategies are appropriate for each particular circumstance.

Since 1987, Offit, Kurman, has been specializing in mergers and acquisitions for buyers and sellers, and also in asset protection for sellers in connection with the sale of their businesses. Our practice areas include business and corporate transactions, estates, trusts and asset protection, labor and employment law, civil and commercial litigation, construction law, real estate, tax, debtor/creditor law and alternative dispute resolution.

Offit, Kurman reserves all rights to this article, including the right to reprint and reproduce this article.

Ted Offit is the Chair of the firm’s Business Practice Group and has substantial experience in the numerous practice areas including Corporations, Partnerships and Limited Liability Companies, Taxation, Mergers and Acquisitions, Financial Planning, Reorganizations for Financially Troubled Companies and Asset Protection Strategies.  Mr. Offit can be reached at toffit@offitkurman.com or (301) 575-0304.

Jesse Delanoy is a partner in the firm’s Business Practice Group, and serves as outside general counsel to many privately-owned businesses, concentrating his practice primarily in the areas of Corporations and Partnerships, Mergers and Acquisitions, Family and Non-Family Business Ownership Transitions, Commercial Contracts, Small Business Planning, Employee Agreements, and Real Estate.  Mr. Delanoy can be reached at jdelanoy@offitkurman.com or (301) 575-0301.