Buying, Selling, and Combining Businesses Under the Colorado Business Corporation Act

This month’s article was written by Robert M. Fogler, Denver, a partner with Kamlet Shepherd & Reichert, LLP—(303) 825-4200, rfogler@kamletlaw.com; and Rob Witwer, Denver, a partner with Kamlet Shepherd & Reichert, LLP.—(303)825-4200, rwitwer@kamletlaw.com.

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The process of buying, selling, and combining businesses is an essential part of the free market system. Merger and acquisition transactions allow entrepreneurs to capture the value of their hard work, investors to put their capital to productive use, and consumers to enjoy the benefits of an efficient marketplace.

At the heart of every merger or acquisition is the transfer of property, whether stock or assets. Although lawyers necessarily play a significant role in this type of transaction, their roles can vary —from scribe to hands-on counselor. This article provides an introduction to the issues attorneys may encounter when advising clients involved in the purchase or sale of businesses under the Colorado Business Corporation Act ("CBCA").¹

This article covers corporate stock sales and mergers under the CBCA.² Attention is given to statutory provisions governing documentation and required procedures, including those governing dissenters’ rights. The article addresses asset sales, with a focus on successor liability. It also covers due diligence issues and discusses approval requirements under Colorado corporate law for acquisitions involving insiders.³ Finally, the article includes drafting tips that are applicable to all types of acquisition structures.

Throughout this article, the term "Seller" is used to refer to the corporation selling its assets, having its stock transferred, or effecting a merger transaction in which it is not the surviving entity. The term "Acquirer" refers to the surviving corporation in a merger or the corporation obtaining the stock or assets of a Seller. "Seller Shareholders" refers to the owners of the Seller’s equity interests.

Choosing a Structure: Mergers, Stock Sales, And Asset Sales

The purchase or sale of a corporation typically is accomplished through one of three legal structures: a merger, stock sale, or asset sale. Deciding which structure to choose depends significantly on legal considerations. Business owners might not be aware of the legal subtleties involved in structuring a transaction, so it is important for counsel to communicate to the client the pros and cons of each respective structure.

In general, structure will be driven by four factors: (1) tax considerations; (2) the portion of the Seller’s business to be acquired; (3) the legal effects of the transaction, as well as the relative complexity or simplicity presented by different structures; and (4) corporate approval requirements. The following discussion considers each of these four factors.

Tax Considerations

Acquirers often prefer asset purchases to stock purchases for tax reasons. For example, where the depreciated book value of the assets is less than their fair market value, an Acquirer in an asset deal takes a tax basis in the acquired assets equal to the amount paid for them. This allows for greater depreciation, which in turn can be offset against profits to reduce tax liability. Conversely, a Seller usually seeks to avoid the tax implications of an asset sale. Not only must the Seller "recapture" the excess depreciation by paying taxes on the difference between fair market value and depreciated book value, but if it is a C corporation, Seller Shareholders are subject to double taxation.

Under the tax laws, a merger may be treated as either an asset sale or stock sale, depending on the entity’s structure.⁴ Under the Internal Revenue Code, a variety of other structures may qualify, in whole or in part, as non-taxable "reorganizations," particularly where the Seller or Seller Shareholders receive stock as consideration for the sale.⁵ A discussion of these provisions is beyond the scope of this article. The prudent practitioner always will consult a tax specialist (accountant or tax lawyer) for assistance with the tax treatment of these different structures.

Portion of Business Being Acquired

Asset sales are appropriate where an Acquirer is purchasing less than the entire business of the Seller. In such cases, the Acquirer takes only the needed assets; the rest are left behind with the Seller who either continues as a going concern or disposes of the remainder of the assets.

Legal Effects

According to conventional wisdom, Acquirers ordinarily prefer to buy assets, whereas Sellers prefer to sell stock. The primary reason for this has to do with allocation of preexisting liabilities. In an asset sale, the Acquirer generally assumes the Seller’s business assets while leaving behind its liabilities.⁶ However, in a stock sale, the Acquirer takes the Seller’s assets and liabilities.

A stock sale is relatively straightforward: Seller Shareholders exchange their stock certificates for cash or other consideration. The Seller retains all of its assets and liabilities; only the identity of its shareholders has changed. Under Colorado law, mergers generally are treated like stock sales. The Acquirer assumes all assets and liabilities by operation of law, without the need for any legal "assignment" or "assumption" of assets and liabilities.

Asset sales are trickier than mergers or stock sales. Any asset or liability reflected in an agreement with a third party—such as customer and vendor contracts or real property leases—must be "assigned" to the Acquirer. The assignment of these contracts often requires the express consent of the other party to the contract.⁷

Employee issues also complicate asset sales. If the employees are going to work for the new business, technically they must be "fired" by the Seller and "rehired" by the Acquirer. This firing and rehiring raises employee benefit issues, such as liability for accrued vacation pay and changes in health and retirement benefits.⁸

In addition, some asset transfers implicate governmental or filing requirements. For example, the transfer of real estate requires formal transfer and filing documentations, including title insurance. Finally, if the Seller has a line of credit or other debt secured by its assets, the line of credit usually must be paid off completely at the closing. Until this is done, the bank or other creditor will not release its liens on the transferred assets.

Corporate Approval Requirements

Mergers under the CBCA generally require the approval of a majority of the shareholders of the Acquirer and Seller.⁹ Asset sales ordinarily require the approval of a majority of the Seller Shareholders.¹⁰ However, stock sales require the approval of all of the Seller Shareholders, assuming that the Acquirer wants to own 100 percent of the business. In a stock sale, any individual shareholder, absent a separate contractual agreement stating otherwise,¹¹ can refuse to sell his or her stock. Most Acquirers do not want the hassle of dealing with a reluctant shareholder, so this refusal sometimes can kill a deal.

A typical work-around solution is to structure the sale as a reverse triangular merger: The Acquirer forms a wholly-owned subsidiary, which merges into the Seller. The net result is the same because the Acquirer owns 100 percent of the Seller’s stock, but the merger transaction only requires the approval of a majority of the Seller Shareholders. A caveat is that an objecting shareholder can choose to exercise his or her dissenter’s rights, although the cost and relative benefit of doing so (as long as the transaction is generally fair to the Seller Shareholders) often dissuades shareholders from troubling themselves with dissenters’ rights.¹²

Mergers

Mergers under the CBCA generally take one of the following three forms.

• Forward Merger: The Seller merges into the Acquirer,¹³ with the Acquirer surviving the merger.
• Forward Triangular Merger: The Seller merges into a wholly-owned subsidiary of the Acquirer, with the subsidiary of the Acquirer surviving the merger.
• Reverse Triangular Merger: A subsidiary formed by the Acquirer for the sole purpose of effecting the merger merges into the Seller, with the Seller surviving as a wholly-owned subsidiary of the Acquirer.

The choice of merger form will be driven by a number of business and practical considerations. For instance, one of the most significant considerations involves tax outcomes.¹⁴

Merger Documentation And Filing Requirements

To effect a merger under the CBCA, the Acquirer must file a statement of merger under the Colorado Corporations and Association Act.¹⁵ Certain provisions are statutorily required to appear in the statement of merger. However, the statement of merger is not permitted to contain any information other than the required statutory elements. For example, it may not include the "plan of merger."¹⁶

Dissenters’ Rights in Mergers

Shareholders may opt to vote against a merger. If such dissenters comply with the CBCA procedures,¹⁷ in lieu of the consideration set forth in the plan of merger, they are entitled to receive: (1) cash equal to the "fair value" of their shares immediately before the effective date of the merger; and (2) interest accruing from the effective date of the merger.

If the shareholder believes that the "fair value" as determined by the corporation is too low, he or she may notify the corporation of the shareholder’s estimate of fair value and demand that the corporation pay the difference.¹⁸ The corporation must then either commence a proceeding in court to determine the fair value or pay the amount demanded.¹⁹

Legal Effects of Mergers

The legal effects of a merger are set forth in CRS § 7-90-204.²⁰ All assets and liabilities of the constituent corporations become vested in the surviving entity by operation of law. This transfer of assets is not deemed an "assignment" that would require consents by third parties. The statute states, in relevant part:

All obligations of the merging entities shall attach as a matter of law to the surviving entity and may be fully enforced against the surviving entity. A merger does not constitute a conveyance, transfer, or assignment.²¹

The law in this area changed in 2004.²² For this reason, practitioners should be careful not to use statutory materials pre-dating such changes.

Short Form Parent-Subsidiary Mergers

Where a parent corporation merges with a subsidiary in which it owns at least 90 percent of the outstanding shares of each class of the subsidiary’s stock, a vote of the shareholders of the subsidiary is not required. In addition, no action is required by the subsidiary’s board of directors.²³ However, the parent must mail a written copy or summary of the plan of merger to all shareholders at least ten days before the effective date of the merger, unless the shareholders waive this notice requirement in writing.²⁴

Moreover, if the parent is the surviving corporation, a vote of the parent company’s shareholders is not required as long as the conditions of CRS § 7-111-103(7) are met. These requirements include: (1) the parent’s articles of incorporation are not amended in any way that requires shareholder approval; (2) the shareholders of the parent will continue to hold the same number and type of shares they held immediately prior to the merger; and (3) the parent will not issue shares in connection with the merger that exceed 20 percent of the shares outstanding prior to the merger.

Stock Sales

In a stock sale, the Seller Shareholders sell their ownership interests in the Seller to the Acquirer in exchange for cash, equity, debt assumption, or other consideration. This should be done subject to a stock purchase agreement containing customary representations, warranties, indemnifications, and covenants. Regardless of the idiosyncrasies of a transaction, counsel should be aware of some considerations common to the majority of stock deals.

Counsel for the Acquirer should be diligent to ensure that once the transaction is consummated, the Acquirer will truly own the Seller free and clear of unexpected encumbrances. At a minimum, the stock purchase agreement should contain representations, warranties, and indemnifications made by the Seller’s Shareholders regarding significant potential problems associated with the Seller’s equity interests. These should include representations and warranties addressing: (1) the capital structure and organization of the Seller; (2) ownership of all outstanding equity interests in the Seller, including a representation that no additional ownership interests exist other than those being sold; (3) the fact that no equity interests are encumbered by liens, claims, or other liabilities; (4) the fact that issuance and transfer of equity and the terms of the transaction are duly authorized by the Seller Shareholders; (5) the fact that the transaction creates no conflicts with any of the Seller’s organic documents or its contracts, including agreements among shareholders; and (6) the fact that the Seller entity itself has unencumbered ownership interests in all of the assets it claims to own.

Acquirers also are wise to negotiate for additional representations and warranties in specific areas about the Seller’s business. For example, these might address:

• Financial matters
• Real and personal property
• Environmental issues
• Contracts
• Employees
• Employee benefits
• Insurance
• Bank and credit agreements
• Indebtedness
• Compliance with laws
• Current or possible litigation
• Intellectual property
• Insider transactions
• Competing businesses.

Depending on the transaction, negotiations might address any number of other areas relating to the nature of the Seller’s business.

Because stock is a "security" under applicable state and federal securities laws, Seller Shareholders should remain mindful of their obligations and potential liability under these laws. In some cases, the anti-fraud provisions of Rule 10b-5 under the Securities Exchange Act of 1934 can create liability for Seller Shareholders, even in the absence of affirmative representations and warranties in the applicable purchase agreement.²⁵

In addition, Seller Shareholders—and the Acquirer, if it is issuing its own stock as consideration for the acquisition—must find an exemption from the registration requirements under applicable federal and state securities laws. Seller Shareholders or Acquirers issuing their own stock in the acquisition generally properly conclude that the transaction is a private resale or private placement transaction exempt from registration under § 4(1) or 4(2), respectively, of the Securities Act of 1933 ("1933 Act").²⁶ Nonetheless, the lawyers involved in the transaction should perform a more detailed analysis in any case in which: (1) the persons receiving stock are not "accredited investors" under Regulation D of the 1933 Act; or (2) the stock is transferred to more than a few persons or entities or it is transferred to persons or entities that will not be actively involved in operating the company whose stock they will hold.

Holdouts

A stock sale often is the simplest way to buy or sell a business because it generally requires the approval or consent only of the particular shareholders selling their stock, and no board or stockholder meeting or approval is required. However, stock sales sometimes present significant challenges. For instance, if an entity has many owners, an Acquirer must deal with numerous shareholders, and there may be holdout shareholders who refuse to sell their stock. If prospective Sellers plan ahead, they can prevent the problem of holdout shareholders (and thereby increase their attractiveness to Acquirers) by putting "drag-along" rights into the relevant shareholder documents.

Drag-along provisions often are contained in an agreement between the company and all of its shareholders. They provide that if a potential acquisition is approved by a certain voting group, all shareholders agree to be "dragged along" in the sale. Such a voting group might comprise a specified percentage of shareholders, or maybe the board of directors (even though board approval is not statutorily required). The provisions should state that if a proposed sale of the company is approved by the required voting group, all shareholders agree: (1) not to raise any objection to the sale; (2) to sell their stock to the purchaser; and (3) to enter into customary agreements covering the stock sale, provided that all shareholders are treated equally on a pro rata basis.

Drag-along provisions should clarify whether the shareholders must remain personally liable for representations and warranties or, as an alternative, whether the purchase agreement may provide that a portion of the purchase price may be deferred or placed into escrow to satisfy liability for breaches of representations and warranties. Further, the agreement should provide that in the case of a proposed merger or asset sale, all shareholders agree to vote in favor of the transaction and waive their dissenters’ rights.

Drafting Issues

There is no such thing as a "one-size-fits-all" stock purchase agreement. Thus, a comprehensive and reliable form should be tailored to reflect the unique issues in a given transaction.

Asset Sales

In an asset sale, the Seller typically sells all or substantially all of its assets to an Acquirer. This should be done subject to an asset purchase agreement containing customary representations, warranties, covenants, and indemnifications. As with stock purchase agreements, there is no "one-size-fits-all" form asset purchase agreement. Counsel are advised to find a reliable form agreement and tailor it to fit the circumstances of a given transaction.

At a minimum, the asset purchase agreement should identify the specific assets to be sold and the form of consideration to be paid in exchange for those assets. As is discussed in more detail below, to avoid successor liability issues, it also is important that the asset purchase agreement address with particularity how the parties intend to allocate responsibility for liabilities, debts, and obligations associated with the assets.

Dissenters’ Rights in Asset Sales

Under Colorado law, shareholders who believe that they will not receive "fair value" for their shareholder interest in a sale of all or substantially all of a Seller’s assets may exercise dissenters’ rights.²⁷ The substantive and procedural requirements for exercising these dissenters’ rights are essentially the same as those for minority shareholders exercising dissenters’ rights in a merger transaction.²⁸

Successor Liability in

Asset Sales

In a 1982 case, the Colorado Court of Appeals stated that as a general rule, "where one company sells or otherwise transfers its assets to another company, the latter is not liable for the debts and liabilities of the transferor."²⁹ Nevertheless, an Acquirer should be aware that this common law rule is subject to several important exceptions.

As discussed below, an Acquirer may be held liable for a Seller’s debts or obligations if any of the following circumstances exist: (1) express or implied assumption of the Seller’s liabilities; (2) merger or consolidation; (3) acquirer is a "mere continuation" of the Seller; (4) fraud; (5) failure to warn; and (6) distribution of products out of state.³⁰ In addition, counsel should be aware that additional successor liability issues may arise under tax, bankruptcy, or environmental law.³¹ In such contexts, counsel should undertake additional research to determine the scope of potential successor liability.

Express or Implied Assumption of Seller’s Liabilities: If the plain language of the asset purchase agreement clearly allocates responsibility for post-closing liabilities, this will be a relatively straightforward inquiry³² under the standard rules of contract interpretation.³³ However, if the agreement is ambiguous or silent with respect to risk allocation (or there is no asset purchase agreement), a court likely will look at the parties’ conduct and assess whether the Acquirer "impliedly" agreed to assume the liability in question.³⁴

The issue of whether an Acquirer "impliedly" agreed to assume a liability turns on the Acquirer’s intent. Intent is a question of fact and will depend on the circumstances of a given transaction. Although no Colorado case has directly addressed this issue, courts in other jurisdictions have found that persuasive evidence of intent to assume liabilities includes: (1) a discounted purchase price³⁵ or lack of consideration altogether;³⁶ (2) assumption by the Acquirer of a large category of liabilities (even if the particular liability at issue is unspecified);³⁷ or (3) continuation of payment of insurance premiums on the part of Acquirer on liabilities arising from the Seller’s products manufactured prior to the sale.³⁸

To avoid a finding of implied assumption, counsel should ensure that an asset purchase agreement clearly and unambiguously allocates responsibility for the Seller’s liabilities, whether accrued, prospective, actual, or potential. Specifically, the agreement should identify the known debts and obligations of the Seller with as much precision as possible. The agreement also should provide clear guidance about how the parties intend to allocate responsibility for liabilities that are undetermined (or undeterminable) at the time of sale.

The effect of the contractual language is to delineate which of the Seller’s liabilities are intended to become liabilities of the Acquirer. For example, the Acquirer may agree to assume only specific "assumed liabilities" of the Seller, which would be listed in the agreement or an attached exhibit. Thus, the Seller’s liabilities (whether known or unknown) other than those specifically identified as "assumed liabilities" would be expressly retained by the Seller (or, if the Seller becomes insolvent, or winds up, by the Seller Shareholders). In the alternative, the Acquirer may agree to assume all liabilities of the Seller (whether known or unknown) except for specific "excluded liabilities," which will be retained by the Seller (or, if the Seller becomes insolvent, or winds up, by the Seller Shareholders).

Merger or Consolidation: An Acquirer may be held liable for the Seller’s liabilities if the asset sale is deemed by a judge to be a merger or consolidation of the Seller and Acquirer. Also known as the "de facto merger" doctrine, this exception is rooted in the general rule that consolidated entities remain liable for the obligations of their respective predecessors.³⁹ Whether a transaction amounts to a merger or consolidation is a question of fact. As one Colorado district court stated, ‘[S]trictly speaking, a consolidation signifies such a union as necessarily results in the creation of a new corporation and the termination of the constituent ones, whereas a merger signifies the absorption of one corporation by another, which retains its name and corporate identity with the added capital, franchises and powers of a merged corporation.”⁴⁰

Facts showing that any of the foregoing has occurred may be persuasive evidence that a transaction amounts to a merger or consolidation.

A transaction may be a merger or consolidation even if the parties believe that is not the case. Courts will weigh facts and draw their own conclusions as to whether a de facto merger occurred. The Acquirer should strive to keep an arm’s length relationship with the Seller and Seller Shareholders at all times, especially after the assets have been conveyed. Such practices include maintaining separate corporate existences (before, during, and after the transaction) and avoiding, to the extent possible, post-sale continuity of shareholders, management, personnel (if applicable), physical location, and general business operations.

Acquirers seeking to avoid successor liability may wish to take steps (through a covenant or other binding obligation) to prevent the immediate post-sale dissolution of the Seller. Acquirers also should avoid making insurance payments on, or otherwise assuming contractual obligations with respect to, assets for which they do not wish to be held accountable.

Acquirer "Mere Continuation" of Seller: This exception is conceptually similar to the "merger or consolidation" exception, and the two may overlap. According to the Tenth Circuit Court of Appeals, a mere continuation, or reorganization of an existing corporation, may be found to exist where there is a continuation of directors and management, shareholder interest, and, in some cases, inadequate consideration. The gravamen of the traditional "mere continuation" exception is the continuation of the entity rather than continuation of the business operation.⁴¹

As with the "merger or consolidation" exception, counsel should ensure that Seller and Acquirer maintain an independent and separate corporate existence before, during, and after the transaction. For example, one Colorado district court has held that there was no continuation when the Seller "continued to exist after the sale and there was no common identity of stock, directors, officers or shareholders" between Seller and Acquirer.⁴²

Fraud: Successor liability will be imputed to the Acquirer if a court determines that the transaction was entered into fraudulently so the Seller could escape liability for its debt.⁴³ This exception is essentially an application of the rule against fraudulent conveyances. Counsel should make sure that consideration for acquired assets bears a reasonable relationship to their fair market value.

Failure to Warn: The Tenth Circuit has held that Acquirers may have a "duty to warn" consumers about defects in products that were manufactured by the Seller.⁴⁴ Whether such a duty exists depends on circumstances. According to the court, "[s]uccession alone does not impose a duty to warn the predecessor’s customers of recently-discovered defects." Instead, the duty "stems from the existence of the relationship between the successor and the customers of the predecessor."⁴⁵ Thus, if the Seller manufactures products, the asset purchase agreement should require that the Seller (or Seller Shareholders, if necessary) make appropriate representations, warranties, and indemnifications regarding the soundness of those products.

Distribution of Products Outside Colorado: When there is inter-state distribution, counsel should be aware that the "mere continuation" exception has been enlarged in some states to include circumstances in which the totality of the transaction demonstrates a basic "continuity of enterprise." In such states, simply continuing the Seller’s business operation might be enough for the Acquirer to be held liable for the Seller’s debts and liabilities.

Similarly, some states have adopted the "product line" exception, under which an Acquirer who purchases the manufacturing business of a Seller and continues output of a line of Seller’s products may be held liable for all products in that line, even if manufactured prior to the sale. Thus, if the Seller’s business involves the manufacture of products, Acquirers should give special attention to the laws of states in which such products are distributed, as the laws of these jurisdictions may expand the scope of potential successor liability.⁴⁶

Due Diligence

No matter how well legal documents are drafted, there is no substitute for thorough due diligence. Acquirers, as well as Seller Shareholders who anticipate receiving Acquirer stock as consideration, have much to gain by being aware of what they are about to own. Understanding the business and "kicking the tires" is the surest way to bring problems to the surface, which in turn reduces the possibility for costly post-closing disputes.

Due Diligence Checklist

Counsel should begin the legal due diligence process with a comprehensive checklist tailored to the transaction. In mergers and stock deals, it is especially important to perform diligence on the company’s books and records, with special attention to corporate resolutions, authorizations, and equity issuances. This provides assurance that the Seller has observed necessary formalities and that its actions are, and will be, duly authorized. Additionally, it allows the Acquirer to understand the capital structure of the entity and to whom outstanding ownership interests belong.

Potential Problem Areas

Legal due diligence should be undertaken in every major area of the Seller’s business to uncover circumstances that could give rise to material problems for the Acquirer in the future. Possible issues could arise in any of the following areas:

• Leases
• Threatened and pending litigation
• Employee agreements, pensions, and benefits
• Financial accounting, including accounts receivable and payable
• Indebtedness, lines of credit, and loans
• Title to assets
• Relationships with major customers and suppliers
• Intellectual property
• Compliance with laws
• Insurance
• Related party transactions
• Competitive issues.

Documents in these subject matter areas likely will contain confidential and proprietary information. For this reason, prior to opening the books, the disclosing party should obtain written assurances from the reviewing party regarding confidential information obtained in due diligence. The reviewing party should specify that confidential information will not be disclosed to third parties (unless required by law) or used to harm the competitive interests of the disclosing party should the transaction fail. Although beyond the scope of this article, confidentiality and nondisclosure agreements are an important component of any business sale or combination.

Review of Books, Records, And Contracts

The Seller’s books and records should be examined to determine what approval rights are held by shareholders. For example, shareholders may have such rights pursuant to a shareholder agreement.

Contracts should be scrutinized for information about duration, events triggering default, and other key terms. Especially where contracts are major Seller assets, counsel should provide the Acquirer with a summary of the key terms of these agreements, and indicate whether the transaction can give rise to a third-party right to terminate or alter the arrangement.

In particular, counsel should look for provisions requiring third-party approval for "change of control" or contract assignment. Depending on how they are drafted, such provisions may give rise to a third-party consent or approval right with respect to the transaction.

Practice Tips for Drafting Agreements

Counsel’s most important job is to memorialize the transaction in writing. Agreements should reflect the idiosyncrasies of the deal and be thorough and clear enough to prevent any confusion in the future. Following is a discussion of some of these key provisions.

Earn-Out Provisions

Especially where Seller Shareholders will continue to be involved in the business after it is sold, it is common to include "earn-out" provisions, whereby a portion of the purchase price depends on the success of the business during the year or two following the sale. Earn-out provisions can provide an efficient method of allocating post-closing operating risk, because they align the interests of the Seller Shareholders and Acquirer to ensure that the business continues to be successful after the acquisition.

Among other things, earn-out provisions alleviate the effects of information disparity, because they punish Seller Shareholders who withhold information that the business is about to suffer. They also encourage Seller Shareholders to assist with any transition issues, including customer relationships. Finally, earn-out provisions discourage Seller Shareholders from inflating financial performance numbers, because the earn-out provisions will usually be tied to past performance.

Earn-out provisions also raise two types of problems. The first is definitional. Earn-out provisions usually are tied to projected revenue or profit numbers. Counsel should take special care to ensure there is little room for disagreement over the accounting of these numbers. Sometimes "revenue" or "earnings" are tied to GAAP definitions, but other times they are not. The parties should clarify exactly which revenue and expenses will count toward the earn-out benchmarks, including specificity about the timing of when revenue is earned and expenses are accrued. These definitions can be especially tricky when the acquired business is incorporated into the Acquirer’s larger operations.

The second problem is operational. If the earn-out benchmarks are not met, the Acquirer may blame the Seller Shareholders for running the business improperly, or investing insufficient resources in the business. A thoughtful purchase agreement will clarify whether the Acquirer is obligated to operate and support the business in a manner consistent with its history.

Caps and Baskets

A key part of any purchase agreement is the indemnification section. It provides that if Sellers or Seller Shareholders misrepresent the state of the Seller’s business, the Acquirer is entitled to compensation. To prevent costly confusion and clarify the scope of indemnification obligations, it often is helpful to include in the agreement some detail about the mechanics of dispute resolution. These include so-called "caps" and "baskets," which also may address "materiality thresholds."

Caps: Purchase agreements usually provide that if Seller Shareholders breach their representations and warranties to the Acquirer, the Acquirer may seek damages from them. If an indemnification cap is in place, however, this right is limited to the cap amount—for example, 10 to 25 percent of the aggregate purchase price.

Caps help Seller Shareholders because they limit uncertainty about whether they will have to refund the purchase price. Caps also encourage Acquirers to perform adequate due diligence, because unless the Seller Shareholders committed fraud, an Acquirer will not be entitled to a full refund if the business fails to meet expectations.

Baskets: It is also common to have basket provisions in agreements, such that an Acquirer cannot seek damages until they exceed a minimum threshold (such as 1 percent of the purchase price). Baskets are designed to avoid petty squabbles over minor disputes. One issue to consider is whether, once damages exceed the basket threshold, the Acquirer may seek compensation for all damages suffered (on a first-dollar basis), or only those damages exceeding the basket.

It may be helpful for the agreement to provide that after the closing, any materiality qualifiers in representations and warranties—such as "there is no material litigation involving the business"—are ignored for indemnification purposes. Instead, the basket serves to replace the materiality qualifier. Thus, if the litigation in question resulted in damages exceeding the basket, it becomes, by definition, material. This type of provision avoids disputes over the proper interpretation of the term "material." The provision may state that the Seller Shareholders’ post-closing liability for breaches of representation and warranties "shall be without regard to any materiality qualifier" in the representations and warranties.

Recourse, Hold-Backs, And Escrows

An Acquirer’s indemnification rights are only as valuable as the creditworthiness of the party or parties against which it seeks redress. For example, if a Seller sells all of its assets and then distributes the proceeds to its shareholders, the Seller itself is left with no money to satisfy indemnification obligations. Thus, if the Acquirer’s only indemnification rights are against the Seller, it may be chasing a bankrupt entity. Similarly, there could be a stock sale in which the Seller has numerous individual shareholders, many of whom are unable to make the Acquirer whole in the event of breach. If the shareholders are severally liable (versus jointly liable) for indemnification obligations, the Acquirer may find itself chasing many individuals with limited assets who have already spent the money they received in the acquisition—a costly proposition with diminishing returns.

Recourse: When an individual Seller Shareholder is wealthy enough to reassure an Acquirer of its ability to indemnify the Acquirer, the purchase agreement may provide that the Acquirer may sue the wealthy Seller Shareholder alone for all breaches of representations and warranties. In this case, the wealthy Seller Shareholder may enter into a side agreement with the other Seller Shareholders, whereby they agree to remain liable to the wealthy Seller Shareholder for their share of any indemnification obligations.

Acquirers also may want to include in the agreement a pre-closing covenant requiring the Seller to obtain a "tail" insurance policy. Such a policy extends the Seller’s existing coverage to include post-closing claims based on events occurring prior to closing. As noted, it is important for the policy to be obtained by the Seller (or, if the Seller is to dissolve, the Seller Shareholders). This shows that the parties ultimately intended for the insured risks to be the responsibility of the Seller (or, in situations where the Seller is dissolved, the Seller Shareholders)—not the responsibility of the Acquirer.

Hold-Backs and Escrows: Another solution is to hold back a portion of the purchase price until the survival period for the representations and warranties has ended, or at least until the Acquirer has a reasonable time period in which to take over the business and assess whether it meets expectations. A variation of the hold-back theme is to place a portion of the purchase price into an escrow account until the survival period has ended.

Requirements for Insider Transactions

Special care is required where a corporation is involved in an acquisition transaction to which a director—or an entity in which a director has a financial interest—is a party. CRS § 7-108-501 addresses this situation head-on by effectively creating three safe harbors. Under this statute, a shareholder cannot sue to seek damages or stop the transaction if the conditions to any safe harbor are met. Such conditions include: (1) the transaction is approved by a majority of the disinterested directors after disclosure of all material facts (including disclosure of relevant directors’ relationships or interests); (2) after disclosure of all material facts, the transaction is approved by a vote of the shareholders in good faith;⁴⁷ or (3) the transaction is fair to the corporation.

In the first two safe harbors—approval by the board or shareholders after disclosure of all "material facts"—a shareholder can still challenge the transaction by arguing that not all "material facts" were adequately disclosed or explained prior to the vote. In the third safe harbor, the shareholder may simply argue that the transaction is not "fair" to the corporation. In each case, terminology may end up being the subject of litigation.

Short of foregoing the deal, a corporation and its directors should do everything they can to ensure that disclosure is adequate and the transaction is fair to shareholders, both in form and substance. To help mitigate the risk that a "conflicting interest transaction" will be challenged, a corporation can adopt the following procedures: (1) appoint a "special committee" of the board, composed entirely of disinterested directors for the sole purpose of assessing and approving the transaction; and (2) give the special committee broad powers, and encourage it to critically assess the proposed transaction. In some instances, it may be helpful to give the special committee further powers to explore and solicit competing transactions, although this is not necessary.

Conclusion

As in all areas of law, the art of transactional counseling ultimately comes down to a lawyer’s ability to apply the law to the unique facts of an individual deal. There is no such thing as a "one-size-fits-all" approach. It is hoped that the tools contained in this article, combined with the practitioner’s knowledge of particular transactions, will assist in the process of providing sound and helpful advice to clients involved in mergers and acquisitions.\

1.NOTES:

The Colorado Business Corporation Act ("CBCA") is found at CRS Title 7, Article 101, §§ -101 to -117.

2. This article focuses primarily on the combination of corporations under the CBCA but does not cover the conversion and merger of entities under the Colorado Corporations and Association Act ("CCA"), which is set forth at CRS §§ 7-90-101 et seq. The CCA allows different types of entities—corporations, partnerships, and limited liability companies—to merge with or convert into one another, and provides the exclusive rules for mergers involving unincorporated entities. See, e.g. (in this issue), Steiner, "Conversion of Entities in Colorado" 33 The Colorado Lawyer 11 (Nov. 2004).

3. Attorneys representing public companies should be aware that, although myriad securities laws will be relevant, a discussion of those considerations is beyond the scope of this article.

4. For tax purposes, forward mergers and reverse triangular mergers are generally treated like stock sales, and forward triangular mergers are generally treated like asset sales. However, these general rules are subject to numerous conditions and exceptions.

5. 26 U.S.C. § 368.

6. See the discussion in the section entitled "Successor Liability in Asset Sales," below.

7. Whether consent is required depends on the language of the contract. If a contract is silent regarding assignment, the general rule under Colorado law is that third-party consent is not required. See generally Scott v. Fox Bros. Enter., Inc., 667 P.2d 773 (Colo.App. 1983). Many contracts, however, provide that assignment requires consent of the other party to the contract. Some contracts go further, stating that consent is required even in the case of a stock sale or merger; these are often called "change of control" provision. Such provisions usually provide that consent is required when a majority of the voting power of the Seller changes hands in a merger or stock sale.

8. See Meyer, "Mergers and Acquisitions: Employees Benefit Considerations," 30 The Colorado Lawyer 57 (June 2001).

9. See CRS § 7-111-103.

10. See CRS § 7-112-102.

11. See the section entitled "Holdouts," below.

12. Dissenter’s rights under Colorado law are discussed in greater detail; see the section entitled "Dissenters’ Rights in Mergers," below.

13. In the context of a merger, the Acquirer is also known as the "surviving corporation."

14. A discussion of tax outcomes is beyond the scope of this article. But see, e.g., Schwarz and Lathrope, Corporate and Partnership Taxation (St. Paul, MN: West Pub., Black Letter Series, 4th ed. 2003). For further information, consult a tax specialist.

15. CRS §§ 7-90-203(5) and 7-111-104.5.

16. CRS §§ 7-90-203(5) and -301(3). For a general overview of the new filing procedures, see Sparkman, "No Paper Required: Business Entity Legislation Makes Life Easier for Business Lawyers," 33 The Colorado Lawyer 11, 14 (June 2004).

17. See CBCA Article 113, Part 2, CRS §§ 7-114-101 et seq.

18. See CRS § 7-113-209.

19. See CRS § 7-113-301.

20. As cross-referenced by CRS § 7-111-106(1). The effects of a merger of two corporations are set forth in CRS § 7-90-204, even if the merger is effected under the CBCA.

21. See CRS § 7-90-204(1)(a). The cited statute was amended by H.B. 04-1398, effective July 1, 2004. See Sparkman, supra, note 16.

22. H.B. 04-1378. See Sparkman, supra, note 16.

23. Although CRS § 7-111-104 does not specifically address subsidiary board action, the Authors’ Comments in the CBCA Deskbook to that section state "no action is required by the board of the subsidiary." Krendl and Krendl, Colorado Business Corporation Deskbook (St. Paul, MN: West Group, 2003).

24. See CRS § 7-111-104.

25. See Harsco Corp. v. Segui, 91 F.3d 337 (2d Cir. 1996). The Securities Exchange Act of 1934 is found at 15 U.S.C. §§ 78a et seq.

26. 15 U.S.C. §§ 77a et seq.

27. See CRS § 7-113-102(c).

28. These issues are discussed in the section entitled "Dissenters’ Rights in Mergers," above.

29. Ruiz v. ExCello Corp., 653 P.2d 415, 416 (Colo.App. 1982).

30. This discussion of successor liability has been modified from an original article by one of the authors. See Witwer, "Successor Liability for Asset Purchasers," 31 The Colorado Lawyer 9 (Aug. 2002). A more detailed discussion of the subject is contained in that article.

31. This is especially true for the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA"). CERCLA is codified at 42 U.S.C. §§ 9601 et seq.

32. See, e.g., Kloberdanz v. Joy Mfg. Co., 288 F.Supp. 817, 821 (D.Colo. 1968) (where asset purchase agreement included exhibit designating liabilities to be assumed by Seller and liability for torts was not included on such exhibit, "it follows that [Seller] was to retain that liability"). See also Colorado Springs Rapid Transit Ry. Co. v. Albrecht, 123 P. 957, 960 (Colo. App. 1912) ("no allegation or proof" that Acquirer expressly agreed to assume Seller’s obligations); Florom v. Elliott Mfg., 867 F.2d 570, 575 n.2 (10th Cir. 1989) ("An unambiguous contract between the seller and purchaser corporations, with explicit provisions which exclude any liability for the debts and liabilities of the predecessor, weighs against [the court’s] finding that [successor liability exists]").

33. See Florom, supra, note 32 at 575 ("Unless the words used by the parties to express their agreement are found to be ambiguous in some material respect, the court should give them legal effect according to their plain, ordinary and popular meaning.").

34. Id. (inquiry into whether assumption occurred directs court "both to the terms of the purchase and the successor’s conduct").

35. See Leyman Corp. v. Piggly-Wiggly Corp., 103 N.E. 2d 399, 403 (Ohio Ct.App. 1951) (Acquirer given purchase price deduction because of its agreement to pay Seller’s debt).

36. See 19 Am.Jur.2d Corporations (St. Paul, MN: West Group, 1986) at § 2709, n.29, citing Diamond A Cattle Co. v. Tschirgi, 181 F.2d 991 (8th Cir. 1950) (in absence of evidence to the contrary, intention to assume liabilities found where corporation’s assets have been taken over without consideration and are used to continue predecessor’s business for successor’s benefit).

37. See Kessinger v. Grefco, Inc., 875 F.2d 153, 155 (7th Cir. 1989) (agreement of Acquirer "to pay, perform and discharge all debts, obligations, contracts and liabilities" of Seller showed intent to assume unforeseen product liability claims, although not specifically addressed in agreement).

38. Florom, supra, note 32 at 576.

39. "The relevance of the de facto merger doctrine to the issue of transferee liability stems from the general principle of law that, absent a governing statute or contract provision, a corporation that absorbs another corporation by merger or creates a new corporation by consolidation, is liable on the debts and obligations of the merged or consolidated corporation, while a corporation that merely acquires the assets of another is not liable for the obligations of the transferor." See 19 Am.Jur.2d Corporations, supra, note 36 at § 2718.

40. Kloberdanz, supra, note 32 at 821.

41. Florom, supra, note 32 at 578.

42. Kloberdanz, supra, note 32 at 821.

43. Ruiz, supra, note 29 at 416.

44. See Florom, supra, note 32 at 576-77.

45. Id.

46. For a survey of successor liability rules in other states, see Pollak, "Successor Liability in Asset Acquisitions," 1187 PLI/Corp. 125, 141 (June 2000).

47. This "good faith" requirement prevents an interested director from relying on the vote of shares he or she owns for the safe harbor.

This article was originally published in the November 2004 edition of The Colorado Lawyer, volume 33, number 11, and is reprinted with permission.