Mergers and Acquisitions

Michael J. Meehan writes:

In a typical purchase agreement (e.g., an asset purchase agreement or stock purchase agreement), the seller  is generally required to convey the property in question “free and clear of all liens and encumbrances.”  If you are an entrepreneur planning an exit, you must have a working knowledge of the concept of “encumbrances.”

In many scenarios, the concept is simple (for example, a buyer may require the payoff of an existing mortgage before purchasing an office building).  But lenders can encumber your corporate property in a variety of other ways.  For example, a lender may require that the assets or receivables of your business be provided as collateral for the loan.  Typically, the lender will prohibit the business from selling the assets in question without the lender’s consent.  Therefore, the sale of the assets results in a potential double-edged sword for you as the business owner, as you risk violating both the purchase agreement (by failing to disclose the encumbrance) and the loan agreement (by transferring the assets without permission).

Consider, for example, a start-up that takes out a line of credit in its early stages.  The line of credit is secured by the company’s assets, including its receivables.  Years later, the company is profitable and operating at several locations, and the owner desires to sell one location to focus on the others.  She finds a buyer and is presented with an asset purchase agreement containing standard encumbrance provisions. Even though she is selling only certain assets of the business (and not the entire business), she still must disclose and address the line of credit because the assets are encumbered by that loan.  Ideally, the business owner can contact the lender and obtain a waiver that permits her to sell the assets; if not, the lender may require that the credit line be reduced or paid off prior to the transfer.

Encumbrances can also arise outside of the lending context.  Tax liens, code violations, property easements, lease restrictions and equipment leases are all potential issues that may need to be disclosed or addressed in response to a standard encumbrance provision.

In helping you prepare for the sale of your business, your corporate attorney will run a lien search on your company to identify encumbrances and liens.  However, not all liens are properly recorded and some can be missed.  Therefore, as an entrepreneur who understands the effect of encumbrances, you can minimize risks, delays or impaired valuations associated with the sale of your business by working with your attorney during the diligence period to identify and address these issues.


Michael J. Meehan is an associate in the firm’s Exton, PA office.

Pennsylvania is becoming an easier place to do business – for both emerging and established companies.  The Entity Transactions Law (“ETL”), effective July 1, 2015, ushers in a simplified, state-of-the-art regime for Pennsylvania businesses engaging in fundamental transactions.

Copyright: somartin / 123RF Stock Photo
Copyright: somartin / 123RF Stock Photo

Two features of the new law are likely to decrease costs and increase efficiency.  First, the ETL streamlines certain fundamental business transactions.  For example, conversions are greatly simplified.  A “conversion” is used when a business wants to change from one entity form to another, such as changing from a LLC into an S corporation.  Under prior Pennsylvania law, a business owner (and his or her legal team) had to create an S corporation and then merge the LLC into the S corporation – often a complex and costly process.  Under the ETL, a conversion is a simple, single-step transaction.

Second, the ETL provides uniform procedures for businesses undertaking four kinds of fundamental transactions:

  • Mergers of one entity into another;
  • Conversions of one entity into another form of entity;
  • Interest Exchanges between two entities (which permit one entity to control another without requiring a merger); and
  • Domestications in Pennsylvania of an entity originally formed in another state.

Under prior Pennsylvania law, each different entity form (corporation, LLC, partnership, etc.) had to comply with its own set of governance rules.  The inconsistent treatment caused increased complexity and transaction costs when different types of entities engaged in certain transactions with one another. Under the ETL, common provisions apply across entity forms, governing fundamental transactions among them and sharing an approach and vocabulary for approving such transactions.  The result is intended to make such transactions simpler, reduced costs and promote corporate growth.

The ETL was signed into law by Governor Corbett as Act 172 in October 2014.  It was drafted by a committee of the Business Law Section of the Pennsylvania Bar Association and based on the Model Entity Transactions Act and Article 1 of the Uniform Business Organizations Code.

Early stage companies with valuable intellectual property often receive solicited or unsolicited opportunities to sell their business, which a buyer may view as a means of acquiring intellectual property.  Differences as to enterprise valuation may be bridged through an “earnout” mechanism whereby the buyer pays an initial amount at closing and, if certain milestones are met post-closing, an additional amount.

Sellers resist earnouts because, following closing, strategic issues that relate directly to the profitability of the business, which in turn directly affect whether an earnout will be paid to the seller, are to be decided by the buyer. As a result, sellers may seek to impose approval rights relating to the buyer’s conduct of the business post-closing.  Buyers will often resist this on the basis of “we bought it, we own it, we run it.”

The end result is often the inclusion of language in the acquisition documentation similar to the language at issue in Lazard Technology Partners, LLC v. Qinetiq North America Operations LLC, where the buyer was prohibited from “tak[ing] any action to divert or defer [revenue] with the intent of reducing or limiting the Earn-out Payment.”  There, when an earnout payment was not forthcoming, the seller sued arguing the buyer had breached its contractual obligations and had violated the implied covenant of good faith and fair dealing which is considered to underlie every commercial transaction.

The Delaware Court of Chancery held for the buyer, finding that the seller had not proven that the buyer had intended to limit the earnout, and that, notwithstanding that the buyer’s actions may have impacted the likelihood of an earnout, the court could not conclude that the buyer intended to reduce or limit the earnout.  The court also found the implied covenant of good faith and fair dealing was not applicable because there was no “gap to be filled” in the heavily negotiated acquisition agreement, which spoke for itself as to the buyer’s obligations.

The Delaware Supreme Court affirmed the Court of Chancery, suggesting that the implied covenant of good faith and fair dealing could exist side by side with a contractual covenant, but ultimately holding “the implied covenant did not prohibit the buyer’s conduct unless the buyer acted with the intent to deprive the seller of an earn-out payment.”

Sellers negotiating earnout arrangements should therefore not rely upon the implied covenant of good faith and fair dealing when the definitive agreement establishes a standard to be applied to the buyer’s post-closing actions.  On the other hand, Buyers should disclaim any implied duty of good faith and fair dealing so as to avoid application of an objective standard that may expand the contractual standard of behavior negotiated by the parties in the acquisition agreement.  This will help to retain focus on the buyer’s intent and will help to limit or eliminate an examination of the ultimate result of any decision by the buyer that conceivably impacts its obligation to make an earnout payment to the seller.