During the last several of years, various forces, including the sluggish real estate market and the less than extraordinary general economy in California have combined to result in an increased number of mergers and acquisitions of independent escrow corporations. This article is a primer which will provide escrow owners with an overview of the acquisition or merger process as it relates to corporations in general, along with an overview of the additional requirements imposed upon escrow corporations by the Department of Corporations and the Escrow Agents' Fidelity Corporation.
Assumptions
For the purposes of this article, it is assumed that both the Purchaser Corporation and the Target Corporation are privately held California corporations, whose stockholders are (A) California residents and (B) the operating officers and directors of the respective corporations. It is further assumed that neither corporation has a subsidiary, nor contemplates forming one to facilitate a subsidiary merger.
Tax Treatment
The tax treatment of an acquisition or merger will often have a significant economic impact upon all parties involved in the transaction. Different transaction structures can lead to drastically different tax results. Certain transactions may be structured to qualify for tax-free treatment. However, generally, when a taxpayer sells, exchanges or otherwise disposes of property, including stock, the taxpayer may realize a gain or loss equal to the difference between the amount realized and the taxpayer's adjusted basis in such property. This article will necessarily address certain tax aspects of particular transactions in order to demonstrate the basic differences in the various acquisition structures. The discussions of tax implications in this article are not intended to fully address the tax ramifications of each type of transaction. Instead, they are intended to present the basic tax structure of each type of transaction, and to serve as a basis for further discussion and review as you contemplate different transaction structures.
- Acquisition Methods
When one corporation desires to acquire the business of another corporation, there are basically three different methods which could be used:
- Purchase the stock of the Target Corporation;
- Purchase the assets of the Target Corporation; or
- Complete a merger of the Purchaser Corporation and Target Corporation.
- Stock Purchases
In many respects, the Stock Purchase is the simplest method of acquisition. The Purchaser Corporation purchases the stock of the Target Corporation from its shareholders. While each shareholder can make his or her own decision whether or not to sell, in most cases the Purchaser Corporation requires 100% of the stock of each individual shareholder of the Target Corporation to be transferred as a condition of the transaction. Assuming, as is usually the case, that the shares of stock are capital assets in the hands of the shareholders, the shareholder's gain or loss on sale is the difference between the amount realized and the shareholder's tax basis in the stock. The Target Corporation could continue in existence as a corporation, following the acquisition, as a subsidiary of the Purchaser Corporation. In the event there is no need to operate a separate subsidiary, the Purchaser Corporation could thereafter go through a statutory merger with an end result of having the subsidiary (Target Corporation) disappear, with only the Purchaser Corporation remaining, now owning the assets, business and liabilities of both Corporations.
- Asset Purchases
The Purchaser Corporation could acquire the business conducted by the Target Corporation by purchasing all of the assets of the Target Corporation and assuming all or certain described liabilities and obligations of the Target Corporation. Again, the Target Corporation could continue in existence as a corporation after the transaction. However, the situation is different from the purchase of stock in two important aspects.
First, the Target Corporation is still owned by the shareholders of the Target Corporation; it has not become a subsidiary of the Purchasing Corporation. Similarly, the Purchasing Corporation now directly owns the Target Corporation's assets and is now responsible for the liabilities and obligations of the Target Corporation assumed by the Purchaser Corporation.
It is important to note that although the Purchaser Corporation may have agreed to assume all the liabilities and obligations of the Target Corporation, the Target Corporation remains liable for those obligations, absent releases from third-party creditors. The purchase agreement usually requires the Purchaser Corporation to indemnify and hold the Target Corporation free and harmless from the liabilities and obligations assumed by the Purchaser Corporation.
Second, the biggest difference in an asset purchase is that the purchase price has been paid to the Target Corporation, not the shareholders of the Target Corporation. In order for the shareholders to receive the cash amounts or other property, they will have to liquidate the Target Corporation, have a dividend declared on its outstanding stock, or obtain such consideration in some other manner (not the subject of this article).
If the Target Corporation is what is known as a C-corporation, it is taxed on the sale of its assets, whether or not it thereafter distributes the sale proceeds to its shareholders upon liquidation or in redemption of its stock. If the Target Corporation liquidates and distributes the sale proceeds to its shareholders, the shareholders will recognize taxable gain or loss equal to the difference between the amount realized and the taxpayer's basis in the stock. This is the infamous "double" tax situation. There are a lot of other tax issues in the liquidation of the Target Corporation and distribution of the sales proceeds and/or redemption of stock. If the Target Corporation is an S-corporation, the gain or loss is passed through to the Shareholder, avoiding the double tax. Again, this is addressed just to demonstrate the different results that may occur based solely on how the deal is structured.
- Mergers
Mergers of two or more corporations are governed by the California Corporations Code. A merger of the Target Corporation into the Purchaser Corporation results in the Purchaser Corporation succeeding to all of the Target Corporation's Assets and all of the Target Corporation's Liabilities. Therefore, at the corporate level, a merger is similar to a sale of all the assets of the Target Corporation to the Purchaser Corporation and assumption of all of the Target Corporation's liabilities by the Purchaser Corporation. The only difference in legal effect is that in the asset purchase, the Target Corporation remains in existence, still owned by its former shareholders; whereas in a merger, the Target Corporation disappears. Under California law, the separate existence of the "disappearing" Target Corporation ceases, and the "surviving" Purchaser Corporation succeeds to all the rights and property of the Target Corporation and is subject to all the debts and liabilities of the Target Corporation as if the Purchaser Corporation had itself incurred them. Any lawsuit in process during the merger may be prosecuted to judgment and binds the Purchaser Corporation. This transfer of liens, liabilities and judgments is one of the main non-tax considerations in determining which acquisition method should be used in any proposed combination.
If an acquisition transaction qualifies as a "reorganization," then it will generally be "tax free" to the Target Corporation and the Target Corporation's shareholders to the extent only certain qualifying consideration is received. The Target Corporation shareholders will not be taxed upon the receipt of qualifying consideration, such as stock of the Purchaser Corporation; and the holding period in such qualifying consideration will include the period that they held their Target Corporation stock. The Target Corporation shareholders' tax basis in such qualifying consideration will generally equal their old tax basis in their Target Corporation stock. Similarly, neither the Target nor the Acquiror will be taxed; and the basis of the Target Corporation (or of the transferee of the Target Corporation's assets involving mergers where the Target Corporation does not survive) in its assets will be unchanged. In the event there is non-qualifying consideration, there may be income or gain recognition. Again, this is an oversimplification of the tax aspects of a merger, and this article does not discuss the differences between "A," "B" and "C" reorganizations. Again, it is mentioned to indicate the need for a tax analysis before agreeing to any particular structure in a proposed transaction.
- Department of Corporations and EAFC
The California Financial Code requires the consent of the Commissioner of Corporations for the transfer or issuance of stock of a licensed escrow company. In order to obtain the Commissioner's consent, the Purchaser Corporation files an application (Form EL 326) with the Department of Corporations. The Department of Corporations requires, as one of the conditions to providing consent to a merger, the Escrow Agent's Fidelity Corporation ("EAFC") verification that both the Target Corporation and the Purchaser Corporation are in compliance with the EAFC Certificate Program. In the case of a merger or in an acquisition where the employees of the Target Corporation are absorbed by the Purchaser Corporation, the employees of the Target Corporation are required to file transfer notices with the EAFC. The Department of Corporations requires each of the Target Corporation employees to submit a Notice of Officers, Directors, Trustees, Employees or Other Persons Directly or Indirectly Compensated by Escrow Agents and Statement of Identity and Employment Application, even though each may have both on file as employees of the Target Corporation.
For a merger, confirmed copies of the Agreement of Merger and Certificates of Approval by the Secretary of State must be filed along with a Notice of Exchange Transaction for Issuance of Shares from the Purchaser Corporation to the Target Corporation shareholders.
Needless to say, if a specific closing date is required to accomplish tax or other requirements for the transaction, or minimize fees paid to the EAFC, the Department of Corporation filings must be started early in the acquisition process.
- The Acquisition Process
The steps outlined below are fairly typical in terms of "what happens when" and "who does what." Obviously, significant variations from this pattern can occur; often times unexpectedly, in any particular transaction.
- Sequences of Events
- Initial Deal Terms; Letter of Intent
The first step in any acquisition is a realization by the parties that there may be a deal to be made. In the best of all worlds, at least the Purchaser Corporation has sought the advice of an attorney familiar with the acquisition process and its CPA to develop acquisition strategy with respect to what type of structure would best suit its needs. However, as a general rule, neither is involved at this phase. The parties' initial discussions should be embodied in a letter of intent at this stage, which would include the basic financial terms, the general structure, and, if desirable, a confidentiality agreement. Depending on the circumstances (such as purchasing or merging with a competitor), it is desirable to have a confidentiality agreement in place before exchanging even the basic financial and other data required to negotiate the basic financial terms and conditions. A letter of intent is usually specifically made unenforceable since there are many material provisions that are left to the Definitive Purchase/Merger Agreement that are left for that process.
- Execution of a Definitive Acquisition / Merger Agreement
The basic areas covered by an acquisition/merger agreement are as follows:
- The Deal Provisions
In a purchase of shares or assets, the consideration and how it will be paid; in a merger, the conversion and exchange of shares. These provisions can be simple for a cash purchase to complex for earnouts or closing balance sheet adjustments, escrow holdback provisions, complex liability exclusions, etc.
- Representations and Warranties
Each party to the transaction makes representations concerning its business and the effect of the transaction on it. A considerable portion of the negotiations center around the extent of the representations and warranties and the indemnity sections described below. Some of the areas covered by representations and warranties are:
- Corporate Organization and Good Standing.
- Capitalization.
- Financial Statements.
- Absences of Undisclosed Liability.
- Litigation Existing.
- Contracts.
- Title to Assets.
- Taxes and Tax Returns.
- No Violation of Laws and Regulations.
- Open Escrows.
- Employee Benefit Plans and Related Matters.
- Labor Issues.
- Insurance Coverage.
- Conduct of the Parties During the Escrow Phase / Covenants
The covenants are agreements by the parties about actions they agree to take, or refrain from taking, between signing the Definitive Agreement and the Closing. The covenants usually cover the parties continuance of the business in the ordinary course and activities each party must undertake to consummate the transaction; e.g., obtain third party consents, Department of Corporations consent, etc., allow the other parties access to the business.
- Conditions
The satisfaction of the conditions negotiated determine whether a party has to go forward and consummate the transaction.
One critical condition almost always found is that the other party's representations and warranties be true at Closing. Other conditions may include receipt of any necessary shareholder approvals, delivery of opinions of opposing counsel as to various matters, receipt of a tax ruling, availability of financing, absence of litigation, etc.
- Indemnification
Most agreements for the acquisition of private companies will provide for indemnification. These provisions provide either or both parties the right to recover post-closing damages for misrepresentations and/or non-compliance with covenants. For instance, a representation that "all taxes have been paid" may be met with a post-closing audit producing tax liability. The indemnity would allow recovery.
- Closing Procedures and Requirements and Miscellaneous General Provisions
These provisions deal with items such as choices of law, termination, remedies, notice and other general provisions.
- The Deal Provisions
- Various Other Agreements
The following are part of most transactions:
- Covenants-Not-To-Compete
- Employment Agreements
- Close Corporation Shareholder Agreements
- Buy-Sell Agreements between Shareholders
- Consulting Agreements
- Escrow Holdback Agreements
- Modifications of Articles of Incorporation, Bylaws and Minutes brought up to date
- The Period Pending the Closing
Once the parties have signed the Definitive Agreement and are waiting for the Closing, a number of items must be accomplished.
- Each of the parties would conduct their due diligence; and
- Consent from the Corporations Commissioner would be sought.
- The Closing
Getting all of the proper consents, governmental approvals, tax declarations, and other items which are out of the direct control of the parties and their representation, is sometimes a juggling act. Escrow officers understand this better than anyone. As we all know, if something can cause a delay, it will; and if a problem can arise, it will. The agreements need to address these contingencies and the parties need to be informed on a frequent basis as to the status of all the items required for the closing.
- Post-Closing
From an attorney's point of view, the major items which remain after the closing are indemnification claims, if any, and price adjustments based on closing balance sheet determinations.
From the business standpoint, the Post-Closing is critical mass:
- Integration of employees;
- New letterhead;
- Integrate business practices;
- Banking changes;
- Escrow file inventory;
- Equipment requirement;
- Additional office space;
- Telephones;
- Insurance;
- Employee benefits;
- Personnel memorandum;
- Etc., etc., etc.
- Initial Deal Terms; Letter of Intent
- Sequences of Events
- Conclusion
An acquisition or merger between the right parties can be the door opening to continued expansion or a prosperous retirement. Hopefully, the above outline will provide you with a road map to a successful transaction.