Best Efforts? Commercially Reasonable Efforts?

Words of caution if you ever use "efforts" clauses instead of unambiguous obligations.

Consider using such clause is the market/industry practice

Use the same terms consistently throughout the agreement

Consider dispute identification mechanism at a sign of dispute or disagreement as to performance

Include temporal limitations and certainty

Consider time frames for efforts including within specific number of days or months from a triggering date or event

Define efforts

Sample definitions in the context of M & A:

• "Efforts that a prudent Person desirous of achieving a result would use in similar circumstances to ensure that such result is achieved as expeditiously as possible on commercially reasonable terms."
• "Efforts that a prudent Person desirous of achieving a result would use in similar circumstances to achieve such result as expeditiously as possible; provided, however, that a Person required to use commercially reasonable efforts under this Agreement will not be required to take actions that would result in a material adverse change in the benefits to such Person of this Agreement and the transactions contemplated hereby or to dispose of or make any change to its business, expend any material funds or incur any other material burden."
• "Efforts consistent with the past practices of similarly situated [INDUSTRY] companies with respect to similarly situated [MATTER]"
• "Efforts consistent with the past practice of [PURCHASER] related to research and development, regulatory approval, commercialization and sales and marketing of similar [PRODUCTS] with similar market potential at a similar stage in development"

Include carve-outs as what efforts clause does not require of covenanting party

• Expense cap in dollar amounts on attorneys' fees and other costs
• Conduct that would reasonably be expected to have a material adverse effect on covenanting party
• Actions that would subject the covenanting party to liabilities
• Actions in contravention of law or regulatory requirements
• Actions that would impact profitability or solvency of the covenanting party
• Fiduciary outs (subject to break-up fee and other deal protections for the buyer)

HSR or other regulatory approvals

• Reverse break-up fee
• Ticking fees that increase based upon length of time it takes to address concerns
• Detailed efforts covenants identifying problematic lines of business or assets to be divested
• Negative covenants of buyer restricting pre-closing acquisition of assets or business or other actions that would exacerbate antitrust problems

Third Party Consents

• Control or specify the timing of pursuing consents, expenses in doing so, and thresholds for closing (must-have consents)
• Consider third party leverages 

Acquisition Financing

• "Buyer  shall, and shall cause its Affiliates to, use commercially reasonable efforts to obtain the Financing on the terms and conditions described in the Financing Letter, including using commercially reasonable efforts to (i) enter into definitive agreements with respect to the Financing (including agreeing to any requested changes to the Financing Letter by the committed lenders in accordance with the related flex provisions), (ii) satisfy (or obtain waiver) on a timely basis of all conditions in such definitive agreements (within buyer's control) and (iii) consummate the Financing contemplated by the Financing Letter at Closing."

NJ Escheat Law in the context of Reverse Triangular Merger

Hypothetical transaction: The target company, the Company, survived the merger and remains as a New Jersey corporation, wholly owned by the Parent, a DE corporation, post-merger. The merger sub created by the Parent for the merger, a New Jersey corporation, merged with and into the Company upon the closing. Assume for the purpose of the analysis, a large percentage of the previous shareholders of the Company were domiciled in New Jersey and a significant number of them have not provided documentation required for the payment of merger consideration.

New Jersey Escheat Law (Title 46, Subtitle 6, Chapter 30B. Unclaimed Property)

These New Jersey statutes provide a procedure by which personal property that is presumed abandoned is transferred to the State of New Jersey as custodian for the absent owner. Property is subject to the custody of the State of New Jersey as unclaimed property if one of the conditions raising a presumption of abandonment (Articles 2 and 5 through 16 of the statutes) exists and one of the other statutorily required conditions (under Section 46:30B-10) is satisfied.

The statutes have the following defined terms that are relevant to an escheat law analysis:

"Administrator" means the Treasurer of the State of New Jersey;
"Apparent owner" means the person whose name appears on the records of the holder as the person entitled to property held, issued, or owing by the holder;
"Domicile" means the state of incorporation of a corporation and the state of the principal place of business of an unincorporated person; and
"Holder" means a person, wherever organized or domiciled, who is the original obligor indebted to another on an obligation (The Company and Parent are deemed to be the holders of the merger consideration under the New Jersey statutes and that the Parent is a Delaware corporation does not prevent the State of New Jersey from reaching out to the Parent for the enforcement of these statutes).

1. Presumption of abandonment
“Stock or other interest in a business association” is presumed abandoned three (3) years after the date of an unpresented instrument issued to pay interest or a dividend or other cash distribution (Article 10; Section 46:30B-31). This section of the NJ statutes is what is considered as the most applicable to the circumstance in terms of the category of the underlying abandoned property. The definition of “business association”  under the statutes includes a corporation.

2. Other condition to be satisfied to subject the property to the custody of the state (basically establishing the nexus to the State of New Jersey):
• The last known address, as shown on the records of the holder, of the apparent owner is in New Jersey (I assume that this should be the case for those previous shareholders of the Company that are known to us as domiciled in New Jersey);
• The records of the holder do not reflect the identity of the person entitled to the property and it is established that the last known address of the person entitled to the property is in New Jersey;
• The records of the holder do not reflect the last known address of the apparent owner, and it is established that (1) the last known address of the person entitled to the property is in New Jersey, or (2) the holder is a domiciliary or a government or governmental subdivision or agency of New Jersey and has not previously paid or delivered the property to the state of the last known address of the apparent owner or other person entitled to the property;
• The last known address, as shown on the records of the holder, of the apparent owner is in a state that does not provide by law for the escheat or custodial taking of the property or its escheat or unclaimed property law is not applicable to the property and the holder is a domiciliary or a government or governmental subdivision or agency of New Jersey;
• The last known address, as shown on the records of the holder, of the apparent owner is in a foreign nation and the holder is a domiciliary or a government or governmental subdivision or agency of New Jersey; or
• The transaction out of which the property arose occurred in New Jersey, and (1) the last known address of the apparent owner or other person entitled to the property is unknown, or (2) the last known address of the apparent owner or other person entitled to the property is in a state that does not provide by law for the escheat or custodial taking of the property or its escheat or unclaimed property law is not applicable to the property, and (3) the holder is a domiciliary of a state that does not provide by law for the escheat or custodial taking of the property or its escheat or unclaimed property law is not applicable to the property.

3. Reporting obligations of holder
A person holding property presumed abandoned and subject to custody as unclaimed property under the statutes must report to the administrator concerning the property (Section 46:30B-46). Forms and other information related to the reporting is found http://www.unclaimedproperty.nj.gov/reporting-info.shtml.

4. Notice to apparent owner (Section 46:30B-49)
Not more than 120 days nor less than 60 days before filing the report required by the statutes, the holder in possession of property presumed abandoned and subject to custody as unclaimed property must send by certified mail, and with return receipt requested, written notice to the apparent owner at the last known address informing the owner that the holder is in possession of property if:

(a) the holder has in its records an address for the apparent owner which the holder's records do not disclose to be inaccurate;
(b) the claim of the apparent owner is not barred by the statute of limitations; and
(c) the property has a value of $50.00 or more.

5. Delivery of property
At the time of the filing of the report, the holder must pay or deliver to the administrator all of the unclaimed property set forth in the report and all accretions thereon unless the owner established the right to receive such property before the property has been delivered or the presumption of abandonment is erroneous (Section 46:30B-57-58).

6. Relief from liabilities  
Upon the payment or delivery of property to the administrator, the State of New Jersey assumes custody and responsibility for the safekeeping of the property. A person who pays or delivers property to the administrator in good faith is relieved of all liability to the extent of the value of the property paid or delivered for any claim then existing or which thereafter may arise or be made in respect to the property (Section 46:30B-61).

Delaware Escheats Law (Title 12, Chapter 11 of the Delaware Code)

The Delaware Code broadly mandates that all property, the title to which has failed and the power of alienation suspended by reason of (a) the death of the owner thereof intestate, leaving no known heir-at-law, (b) the owner having disappeared or missing from the last known address continuously for 5 years or more, or (c) such property having been abandoned, must descend to the State of Delaware as an escheat.

Unlike the New Jersey statutes, which do not limit the definition of “holder” based upon the jurisdiction of organization/incorporation or domicile, the Delaware Code specifically provides that the “issuer of any intangible ownership interest in a corporation, whether or not represented by a stock certificate, which is registered on stock transfer or other like books of the issuer or its agent, shall be deemed a “holder” of such property (Section 1198(7) definition of “holder”).”

Since the obligations to (a) report with respect to the abandoned property and (b) pay or deliver such property under the Delaware Code fall on the “holder” of the property, it does not appear that the Delaware law applies to our circumstance where the issuer corporation is a New Jersey corporation, which is not considered a “holder” under the Delaware Code.

Conclusion: Based upon the interpretation of the applicable sections of the statutes above, after three (3) years from the date the Parent or Company contacted, for disbursement of the merger consideration, the previous shareholders of the Company known to the Company or Parent as domiciled in New Jersey, who have failed to submit the required documentation, the presumption of abandonment arises, which obligates the Company/Parent to (a) report to the Treasurer of the State of New Jersey concerning the property, (b) send written notice to the apparent owner at the last known address informing the owner that the Company/Parent is in possession of property, and (c) deliver to the Treasurer of the State of New Jersey all of the unclaimed property set forth in the report (the pro rata merger consideration for each such shareholder) and all accretions thereon.

Tax - F Reorganization - Deferring Tax Obligations of Target Company's Equity Holders

Under F reorganization (IRC 368(a)(1)(F)), the equity holders of Target first transfer all of their equity interest to a newly formed corporation, Newco. This first step can be accomplished either by a direct transfer in exchange for Newco Stock, or by Newco setting up a new subsidiary that merges with and into Target, with Target equity holders receiving Newco stock in the merger.

Next, Target converts into a Target LLC wholly owned by Newco. These two steps constitute the so-called F reorganization. For tax purposes, after these two steps, Newco is considered to be a continuation of the same corporation as Target, and the assets owned by the Target LLC are treated as being owned by Newco.

Then, Newco sells all of the Target LLC (think of this like an asset holding vehicle) ownership interests to Buyer. Newco's sale of the Target LLC ownership interests to Buyer is treated as a sale of the assets of the Target LLC to Buyer (step up basis for Buyer).

Advantages of this F reorganization includes:

• No physical transfer of assets to Buyer
• No deemed liquidation of Target unlike in other instances where a physical transfer of assets are avoided; that is, Newco may stay alive with the cash proceeds of the sale of the Target LLC ownership interests, thus avoiding tax on the proceeds of the sale from the seller equity holders' perspective
• Newco is able to retain those assets not sold to Buyer without any tax on such assets because during the period in which Target is an LLC wholly owned by Newco, Target LLC is treated as part of Newco and therefore can distribute assets to Newco without tax consequences. Newco then can sell the interests in Target LLC and is treated as selling the assets held by Target LLC.

Ex. Sole member (Seller) of an IA LLC (S corp) plans to sell all of his membership interests therein to Buyer. Seller sets up a DE corp (S corp) as the Newco to retain the sale proceeds therein (not a liquidation, no taxable event). Since S corp IA LLC (Opco) may not have a corporate member-owner, Seller converts IA LLC to IA corporation and Newco immediately elects to treat IA corporation as a qualified S corp (Q-sub) as defined under IRC 1361(b)(3). Seller transfer all of his shares in IA corporation (Q-sub) to Newco (1st step of F reorg). IA corporation converts to a DE LLC (2nd step of F reorg), which terminates the Q-sub election. 

If a Q-Sub election terminates, the former Q-Sub (IA corporation) is treated as a new corporation (DE LLC) acquiring all of its assets (and assuming all of its liabilities) immediately before the termination from the S corporation parent in exchange for stock of the new corporation (to be held by the S corporation parent). (26 C.F.R. 1.1361-5 - Termination of QSub election).

Newco then sells all of its membership interests in the DE LLC to Buyer.

Tax - Treasury Regulations of Incentive Stock Options and Plans

§1.422-2   Incentive stock options defined.

(a) Incentive stock option defined—(1) In general. The term incentive stock option means an option that meets the requirements of paragraph (a)(2) of this section on the date of grant. An incentive stock option is also subject to the $100,000 limitation described in §1.422-4. An incentive stock option may contain a number of permissible provisions that do not affect the status of the option as an incentive stock option. See §1.422-5 for rules relating to permissible provisions of an incentive stock option.

(2) Option requirements. To qualify as an incentive stock option under this section, an option must be granted to an individual in connection with the individual's employment by the corporation granting such option (or by a related corporation as defined in §1.421-1(i)(2)), and granted only for stock of any of such corporations. In addition, the option must meet all of the following requirements—

(i) It must be granted pursuant to a plan that meets the requirements described in paragraph (b) of this section;

(ii) It must be granted within 10 years from the date of the adoption of the plan or the date such plan is approved by the stockholders, whichever is earlier (see paragraph (c) of this section);

(iii) It must not be exercisable after the expiration of 10 years from the date of grant (see paragraph (d) of this section);

(iv) It must provide that the option price per share is not less than the fair market value of the share on the date of grant (see paragraph (e) of this section);

(v) By its terms, it must not be transferrable by the individual to whom the option is granted other than by will or the laws of descent and distribution, and must be exercisable, during such individual's lifetime, only by such individual (see §§1.421-1(b)(2) and 1.421-2(c)); and

(vi) Except as provided in paragraph (f) of this section, it must be granted to an individual who, at the time the option is granted, does not own stock possessing more than 10 percent of the total combined voting power of all classes of stock of the corporation employing such individual or of any related corporation of such corporation.

(3) Amendment of option terms. Except as otherwise provided in §1.424-1, the amendment of the terms of an incentive stock option may cause it to cease to be an option described in this section. If the terms of an option that has lost its status as an incentive stock option are subsequently changed with the intent to re-qualify the option as an incentive stock option, such change results in the grant of a new option on the date of the change. See §1.424-1(e).

(4) Terms provide option not an incentive stock option. If the terms of an option, when granted, provide that it will not be treated as an incentive stock option, such option is not treated as an incentive stock option.

(b) Option plan—(1) In general. An incentive stock option must be granted pursuant to a plan that meets the requirements of this paragraph (b). The authority to grant other stock options or other stock-based awards pursuant to the plan, where the exercise of such other options or awards does not affect the exercise of incentive stock options granted pursuant to the plan, does not disqualify such incentive stock options. The plan must be in writing or electronic form, provided that such writing or electronic form is adequate to establish the terms of the plan. See §1.422-5 for rules relating to permissible provisions of an incentive stock option.

(2) Stockholder approval. (i) The plan required by this paragraph (b) must be approved by the stockholders of the corporation granting the incentive stock option within 12 months before or after the date such plan is adopted. Ordinarily, a plan is adopted when it is approved by the granting corporation's board of directors, and the date of the board's action is the reference point for determining whether stockholder approval occurs within the applicable 24-month period. However, if the board's action is subject to a condition (such as stockholder approval) or the happening of a particular event, the plan is adopted on the date the condition is met or the event occurs, unless the board's resolution fixes the date of approval as the date of the board's action.

(ii) For purposes of paragraph (b)(2)(i) of this section, the stockholder approval must comply with the rules described in §1.422-3.

(iii) The provisions relating to the maximum aggregate number of shares to be issued under the plan (described in paragraph (b)(3) of this section) and the employees (or class or classes of employees) eligible to receive options under the plan (described in paragraph (b)(4) of this section) are the only provisions of a stock option plan that, if changed, must be re-approved by stockholders for purposes of section 422(b)(1). Any increase in the maximum aggregate number of shares that may be issued under the plan (other than an increase merely reflecting a change in the number of outstanding shares, such as a stock dividend or stock split), or change in the designation of the employees (or class or classes of employees) eligible to receive options under the plan is considered the adoption of a new plan requiring stockholder approval within the prescribed 24-month period. In addition, a change in the granting corporation or the stock available for purchase or award under the plan is considered the adoption of a new plan requiring new stockholder approval within the prescribed 24-month period. Any other changes in the terms of an incentive stock option plan are not considered the adoption of a new plan and, thus, do not require stockholder approval.

(3) Maximum aggregate number of shares. (i) The plan required by this paragraph (b) must designate the maximum aggregate number of shares that may be issued under the plan through incentive stock options. If nonstatutory options or other stock-based awards may be granted, the plan may separately designate terms for each type of option or other stock-based awards and designate the maximum number of shares that may be issued under such option or other stock-based awards. Unless otherwise specified, all terms of the plan apply to all options and other stock-based awards that may be granted under the plan.

(ii) A plan that merely provides that the number of shares that may be issued as incentive stock options under such plan may not exceed a stated percentage of the shares outstanding at the time of each offering or grant under such plan does not satisfy the requirement that the plan state the maximum aggregate number of shares that may be issued under the plan. However, the maximum aggregate number of shares that may be issued under the plan may be stated in terms of a percentage of the authorized, issued, or outstanding shares at the date of the adoption of the plan. The plan may specify that the maximum aggregate number of shares available for grants under the plan may increase annually by a specified percentage of the authorized, issued, or outstanding shares at the date of the adoption of the plan. A plan which provides that the maximum aggregate number of shares that may be issued as incentive stock options under the plan may change based on any other specified circumstances satisfies the requirements of this paragraph (b)(3) only if the stockholders approve an immediately determinable maximum aggregate number of shares that may be issued under the plan in any event.

(iii) It is permissible for the plan to provide that, shares purchasable under the plan may be supplied to the plan through acquisitions of stock on the open market; shares purchased under the plan and forfeited back to the plan; shares surrendered in payment of the exercise price of an option; shares withheld for payment of applicable employment taxes and/or withholding obligations resulting from the exercise of an option.

(iv) If there is more than one plan under which incentive stock options may be granted and stockholders of the granting corporation merely approve a maximum aggregate number of shares that are available for issuance under such plans, the stockholder approval requirements described in paragraph (b)(2) of this section are not satisfied. A separate maximum aggregate number of shares available for issuance pursuant to incentive stock options must be approved for each plan.

(4) Designation of employees. The plan described in this paragraph (b), as adopted and approved, must indicate the employees (or class or classes of employees) eligible to receive the options or other stock-based awards to be granted under the plan. This requirement is satisfied by a general designation of the employees (or the class or classes of employees) eligible to receive options or other stock-based awards under the plan. Designations such as “key employees of the grantor corporation”; “all salaried employees of the grantor corporation and its subsidiaries, including subsidiaries which become such after adoption of the plan;” or “all employees of the corporation” meet this requirement. This requirement is considered satisfied even though the board of directors, another group, or an individual is given the authority to select the particular employees who are to receive options or other stock-based awards from a described class and to determine the number of shares to be optioned or granted to each such employee. If individuals other than employees may be granted options or other stock-based awards under the plan, the plan must separately designate the employees or classes of employees eligible to receive incentive stock options.

(5) Conflicting option terms. An option on stock available for purchase or grant under the plan is treated as having been granted pursuant to a plan even if the terms of the option conflict with the terms of the plan, unless such option is granted to an employee who is ineligible to receive options under the plan, options have been granted on stock in excess of the aggregate number of shares which may be issued under the plan, or the option provides otherwise.

(6) The following examples illustrate the principles of this paragraph (b):

Example 1. Stockholder approval. (i) S Corporation is a subsidiary of P Corporation, a publicly traded corporation. On January 1, 2006, S adopts a plan under which incentive stock options for S stock are granted to S employees.

(ii) To meet the requirements of paragraph (b)(2) of this section, the plan must be approved by the stockholders of S (in this case, P) within 12 months before or after January 1, 2006.

(iii) Assume the same facts as in paragraph (i) of this Example 1, except that the plan was adopted on January 1, 2010. Assume further that the plan was approved by the stockholders of S (in this case, P) on March 1, 2010. On January 1, 2012, S changes the plan to provide that incentive stock options for P stock will be granted to S employees under the plan. Because there is a change in the stock available for grant under the plan, the change is considered the adoption of a new plan that must be approved by the stockholder of S (in this case, P) within 12 months before or after January 1, 2012.

Example 2. Stockholder approval. (i) Assume the same facts as in paragraph (i) of Example 1, except that on March 15, 2007, P completely disposes of its interest in S. Thereafter, S continues to grant options for S stock to S employees under the plan.

(ii) The new S options are granted under a plan that meets the stockholder approval requirements of paragraph (b)(2) of this section without regard to whether S seeks approval of the plan from the stockholders of S after P disposes of its interest in S.

(iii) Assume the same facts as in paragraph (i) of this Example 2, except that under the plan as adopted on January 1, 2006, only options for P stock are granted to S employees. Assume further that after P disposes of its interest in S, S changes the plan to provide for the grant of options for S stock to S employees. Because there is a change in the stock available for purchase or grant under the plan, under paragraph (b)(2)(iii) of this section, the stockholders of S must approve the plan within 12 months before or after the change to the plan to meet the stockholder approval requirements of paragraph (b) of this section.

Example 3. Stockholder approval. (i) Corporation X maintains a plan under which incentive stock options may be granted to all eligible employees. Corporation Y does not maintain an incentive stock option plan. On May 15, 2006, Corporation X and Corporation Y consolidate under state law to form one corporation. The new corporation will be named Corporation Y. The consolidation agreement describes the Corporation X plan, including the maximum aggregate number of shares available for issuance pursuant to incentive stock options after the consolidation and the employees eligible to receive options under the plan. Additionally, the consolidation agreement states that the plan will be continued by Corporation Y after the consolidation and incentive stock options will be issued by Corporation Y. The consolidation agreement is unanimously approved by the shareholders of Corporations X and Y on May 1, 2006. Corporation Y assumes the plan formerly maintained by Corporation X and continues to grant options under the plan to all eligible employees.

(ii) Because there is a change in the granting corporation (from Corporation X to Corporation Y), under paragraph (b)(2)(iii) of this section, Corporation Y is considered to have adopted a new plan. Because the plan is fully described in the consolidation agreement, including the maximum aggregate number of shares available for issuance pursuant to incentive stock options and employees eligible to receive options under the plan, the approval of the consolidation agreement by the shareholders constitutes approval of the plan. Thus, the shareholder approval of the consolidation agreement satisfies the shareholder approval requirements of paragraph (b)(2) of this section, and the plan is considered to be adopted by Corporation Y and approved by its shareholders on May 1, 2006.

Example 4. Maximum aggregate number of shares. X Corporation maintains a plan under which statutory options and nonstatutory options may be granted. The plan designates the number of shares that may be used for incentive stock options. Because the maximum aggregate number of shares that will be used for incentive stock options is designated in the plan, the requirements of paragraph (b)(3) of this section are satisfied.

Example 5. Maximum aggregate number of shares. Y Corporation adopts an incentive stock option plan on November 1, 2006. On that date, there are two million outstanding shares of Y Corporation stock. The plan provides that the maximum aggregate number of shares that may be issued under the plan may not exceed 15% of the outstanding number of shares of Y Corporation on November 1, 2006. Because the maximum aggregate number of shares that may be issued under the plan is designated in the plan, the requirements of paragraph (b)(3) of this section are met.

Example 6. Maximum aggregate number of shares. (i) B Corporation adopts an incentive stock option plan on March 15, 2005. The plan provides that the maximum aggregate number of shares available for issuance under the plan is 50,000, increased on each anniversary date of the adoption of the plan by 5 percent of the then-outstanding shares.

(ii) Because the maximum aggregate number of shares is not designated under the plan, the requirements of paragraph (b)(3) of this section are not met.

(iii) Assume the same facts as in paragraph (i) of this Example 6, except that the plan provides that the maximum aggregate number of shares available under the plan is the lesser of (a) 50,000 shares, increased each anniversary date of the adoption of the plan by 5 percent of the then-outstanding shares, or (b) 200,000 shares. Because the maximum aggregate number of shares that may be issued under the plan is designated as the lesser of one of two numbers, one of which provides an immediately determinable maximum aggregate number of shares that may be issued under the plan in any event, the requirements of paragraph (b)(3) of this section are met.

(c) Duration of option grants under the plan. An incentive stock option must be granted within 10 years from the date that the plan under which it is granted is adopted or the date such plan is approved by the stockholders, whichever is earlier. To grant incentive stock options after the expiration of the 10-year period, a new plan must be adopted and approved.

(d) Period for exercising options. An incentive stock option, by its terms, must not be exercisable after the expiration of 10 years from the date such option is granted, or 5 years from the date such option is granted to an employee described in paragraph (f) of this section. An option that does not contain such a provision when granted is not an incentive stock option.

(e) Option price. (1) Except as provided by paragraph (e)(2) of this section, the option price of an incentive stock option must not be less than the fair market value of the stock subject to the option at the time the option is granted. The option price may be determined in any reasonable manner, including the valuation methods permitted under §20.2031-2 of this chapter, so long as the minimum price possible under the terms of the option is not less than the fair market value of the stock on the date of grant. For general rules relating to the option price, see §1.421-1(e). For rules relating to the determination of when an option is granted, see §1.421-1(c).

(2)(i) If a share of stock is transferred to an individual pursuant to the exercise of an option which fails to qualify as an incentive stock option merely because there was a failure of an attempt, made in good faith, to meet the option price requirements of paragraph (e)(1) of this section, the requirements of such paragraph are considered to have been met. Whether there was a good-faith attempt to set the option price at not less than the fair market value of the stock subject to the option at the time the option was granted depends on the relevant facts and circumstances.

(ii) For publicly held stock that is actively traded on an established market at the time the option is granted, determining the fair market value of such stock by the appropriate method described in §20.2031-2 of this chapter establishes that a good-faith attempt to meet the option price requirements of this paragraph (e) was made.

(iii) For non-publicly traded stock, if it is demonstrated, for example, that the fair market value of the stock at the date of grant was based upon an average of the fair market values as of such date set forth in the opinions of completely independent and well-qualified experts, such a demonstration generally establishes that there was a good-faith attempt to meet the option price requirements of this paragraph (e). The optionee's status as a majority or minority stockholder may be taken into consideration.

(iv) Regardless of whether the stock offered under an option is publicly traded, a good-faith attempt to meet the option price requirements of this paragraph (e) is not demonstrated unless the fair market value of the stock on the date of grant is determined with regard to nonlapse restrictions (as defined in §1.83-3(h)) and without regard to lapse restrictions (as defined in §1.83-3(i)).

(v) Amounts treated as interest and amounts paid as interest under a deferred payment arrangement are not includible as part of the option price. See §1.421-1(e)(1). An attempt to set the option price at not less than fair market value is not regarded as made in good faith where an adjustment of the option price to reflect amounts treated as interest results in the option price being lower than the fair market value on which the option price was based.

(3) Notwithstanding that the option price requirements of paragraphs (e)(1) and (2) of this section are satisfied by an option granted to an employee whose stock ownership exceeds the limitation provided by paragraph (f) of this section, such option is not an incentive stock option when granted unless it also complies with paragraph (f) of this section. If the option, when granted, does not comply with the requirements described in paragraph (f) of this section, such option can never become an incentive stock option, even if the employee's stock ownership does not exceed the limitation of paragraph (f) of this section when such option is exercised.

(f) Options granted to certain stockholders. (1) If, immediately before an option is granted, an individual owns (or is treated as owning) stock possessing more than 10 percent of the total combined voting power of all classes of stock of the corporation employing the optionee or of any related corporation of such corporation, then an option granted to such individual cannot qualify as an incentive stock option unless the option price is at least 110 percent of the stock's fair market value on the date of grant and such option by its terms is not exercisable after the expiration of 5 years from the date of grant. For purposes of determining the minimum option price for purposes of this paragraph (f), the rules described in paragraph (e)(2) of this section, relating to the good-faith determination of the option price, do not apply.

(2) For purposes of determining the stock ownership of the optionee, the stock attribution rules of §1.424-1(d) apply. Stock that the optionee may purchase under outstanding options is not treated as stock owned by the individual. The determination of the percentage of the total combined voting power of all classes of stock of the employer corporation (or of its related corporations) that is owned by the optionee is made with respect to each such corporation in the related group by comparing the voting power of the shares owned (or treated as owned) by the optionee to the aggregate voting power of all shares of each such corporation actually issued and outstanding immediately before the grant of the option to the optionee. The aggregate voting power of all shares actually issued and outstanding immediately before the grant of the option does not include the voting power of treasury shares or shares authorized for issue under outstanding options held by the individual or any other person.

(3) Examples. The rules of this paragraph (f) are illustrated by the following examples:

Example 1. (i) E, an employee of M Corporation, owns 15,000 shares of M Corporation common stock, which is the only class of stock outstanding. M has 100,000 shares of its common stock outstanding. On January 1, 2005, when the fair market value of M stock is $100, E is granted an option with an option price of $100 and an exercise period of 10 years from the date of grant.

(ii) Because E owns stock possessing more than 10 percent of the total combined voting power of all classes of M Corporation stock, M cannot grant an incentive stock option to E unless the option is granted at an option price of at least 110 percent of the fair market value of the stock subject to the option and the option, by its terms, expires no later than 5 years from its date of grant. The option granted to E fails to meet the option-price and term requirements described in paragraph (f)(1) of this section and, thus, the option is not an incentive stock option.

(iii) Assume the same facts as in paragraph (i) of this Example 1, except that E's father and brother each owns 7,500 shares of M Corporation stock, and E owns no M stock in E's own name. Because under the attribution rules of §1.424-1(d), E is treated as owning stock held by E's parents and siblings, M cannot grant an incentive stock option to E unless the option price is at least 110 percent of the fair market value of the stock subject to the option, and the option, by its terms, expires no later than 5 years from the date of grant.

Example 2. Assume the same facts as in paragraph (i) of this Example 1. Assume further that M is a subsidiary of P Corporation. Regardless of whether E owns any P stock and the number of P shares outstanding, if P Corporation grants an option to E which purports to be an incentive stock option, but which fails to meet the 110-percent-option-price and 5-year-term requirements, the option is not an incentive stock option because E owns more than 10 percent of the total combined voting power of all classes of stock of a related corporation of P Corporation (i.e., M Corporation). An individual who owns (or is treated as owning) stock in excess of the ownership specified in paragraph (f)(1) of this section, in any corporation in a group of corporations consisting of the employer corporation and its related corporations, cannot be granted an incentive stock option by any corporation in the group unless such option meets the 110-percent-option-price and 5-year-term requirements of paragraph (f)(1) of this section.

Example 3. (i) F is an employee of R Corporation. R has only one class of stock, of which 100,000 shares are issued and outstanding. F owns no stock in R Corporation or any related corporation of R Corporation. On January 1, 2005, R grants a 10-year incentive stock option to F to purchase 50,000 shares of R stock at $3 per share, the fair market value of R stock on the date of grant of the option. On April 1, 2005, F exercises half of the January option and receives 25,000 shares of R stock that previously were not outstanding. On July 1, 2005, R grants a second 50,000 share option to F which purports to be an incentive stock option. The terms of the July option are identical to the terms of the January option, except that the option price is $3.25 per share, which is the fair market value of R stock on the date of grant of the July option.

(ii) Because F does not own more than 10% of the total combined voting power of all classes of stock of R Corporation or any related corporation on the date of the grant of the January option and the pricing requirements of paragraph (e) of this section are satisfied on the date of grant of such option, the unexercised portion of the January option remains an incentive stock option regardless of the changes in F's percentage of stock ownership in R after the date of grant. However, the July option is not an incentive stock option because, on the date that it is granted, F owns 20 percent (25,000 shares owned by F divided by 125,000 shares of R stock issued and outstanding) of the total combined voting power of all classes of R Corporation stock and, thus the pricing requirements of paragraph (f)(1) of this section are not met.

(iii) Assume the same facts as in paragraph (i) of this Example 3 except that the partial exercise of the January incentive stock option on April 1, 2003, is for only 10,000 shares. Under these circumstances, the July option is an incentive stock option, because, on the date of grant of the July option, F does not own more than 10 percent of the total combined voting power (10,000 shares owned by F divided by 110,000 shares of R issued and outstanding) of all classes of R Corporation stock.

[T.D. 9144, 69 FR 46412, Aug. 3, 2004; T.D. 9471, 74 FR 59077, Nov. 17, 2009]

Why Investing Companies Care About 20% Voting Power Threshold in Portfolio Companies

If a company/venture capital firm/other fund invests in another firm, whether it's for certain strategic purposes or for a return on investment, that investment must be accounted for on the investing firm’s balance sheet. Accounting rules dictate the method to use to report the investment. Either the cost method and the equity method applies when your ownership interest in the other company is less than a controlling financial interest (more than 50% of the investee’s equity).

Presumption of Ability to Exercise Significant Influence at 20% Voting Power – may be overcome based on facts and circumstances

A stock investment in a corporate entity (portfolio company) that results in an ownership of 20% or greater of the portfolio company’s outstanding shares of voting stock leads to a presumption that the investor has the ability to exercise significant influence over the portfolio company, in which case the investor must apply the “equity method” of accounting to the investment. With the equity method, the balance sheet value of the investment changes according to the net income (the profit) of the portfolio company and report the gain as revenue on your income statement. For example, if the portfolio company had a net loss in a fiscal year, the investor would decrease the value of the investment by its share of the loss (pro rata) on the balance sheet and report the decline as an expense on its income statement. On the other hand, if the portfolio company had a net income in a fiscal year, the investor would increase the value of the investment by its share of the income (pro rata) on its balance sheet and report the gain as revenue on its income statement. Dividends from the investment are considered a return on invested capital, not revenue. The investor would decrease the value of the investment by the amount of any dividends received.

The equity method may be required for investments in certain types of entities at much lower ownership levels than 20%. For example, investments in LP, LLC, trust or other structures that maintain specific ownership accounts are accounted for using the equity method when the investor has an ownership interest of 3% to 5% or greater.

Presumption of Passive Investment at less than 20% Voting Power – may be overcome based on facts and circumstances

A stock investment in a corporate entity (portfolio company) that results in an ownership of less than 20% of the portfolio company’s outstanding shares of voting stock leads to a presumption that the investment is passive investment, in which case either cost (ASC-325-20) or fair value (ASC 320) method applies based upon the nature of the investment.

ASC 320-10-20

Equity Security

“Any security representing an ownership interest in an entity (e.g., common, preferred, or other capital stock) or the right to acquire (e.g., warrants, rights and call options) or dispose of (e.g., put options) an ownership interest in an entity at fixed or determinable prices.” The term, equity security, does not include the following:

·         Written equity options (because they represent obligations of the writer, not investments)

·         Cash-settled options on equity securities or options on equity-based indexes (because those instruments do not represent ownership interest in an entity)

·         Convertible debt or preferred stock that by its terms either must be redeemed by the issuer or is redeemable at the option of the investor

How to Set Exercise Price of Underlying Shares in Granting Stock Options as Compensation

The answer is by a reasonable valuation method to make it fair market value at the time of the grant. Recipients of stock options with exercise prices that cannot be shown to be at or above the “reasonably-determined FMV” on the date of grant face immediate tax on vesting at a combined federal and state tax rate as high as 85% or more.

An issuer of stock options may avoid such issue by using an IRS-approved valuation method, which shifts the burden of proof that the FMV determination method was reasonable or unreasonable from the issuer to the IRS, reducing the likelihood of successful challenges by the IRS.

Section 409A (https://www.irs.gov/irb/2007-19_IRB/ar07.html) of the Internal Revenue Code and Some State Laws

·         From Option Holder’s Perspective

Section 409A requires an option holder with an option having an exercise price below FMV at the time of grant to recognize the taxable income (federal income and employment taxes) equal to the spread between the FMV and the exercise price (FMV – exercise price) as they vest, not at the time the holder exercises the option nor at the time the holder dispose of the shares underlying the options.

Moreover, an additional 20% + federal tax also applies as the option vests. Certain states like California will also have parallel statutes that impose additional 20% + state tax on top of the state regular income and employment taxes.

·         From Issuer’s Perspective

For companies granting stock options to its employees and withholding the income and employment taxes, upon failure to properly withhold these taxes, such companies could be liable for these taxes plus penalties and interest.

Establishing a Defensible FMV

Section 409A approves three valuation methods as reasonable. Such valuations are valid up to 12 months unless there are intervening events that would reasonably and materially impact the valuations (e.g., (e.g., the resolution of material litigation, the issuance of a material patent, a financing, an acquisition, a new material customer or other significant corporate event).

·         Formula-based Valuation: not commonly used

·         Independent Expert Valuation: Section 409A allows the FMV to be established presumptively by qualified independent valuation experts using certain methods recognized under the IRC.

·         Illiquid Startup Inside Valuation.  A valuation will also be presumed to meet the requirements of Section 409A if it was prepared by someone that the company issuer reasonably determines is qualified to perform such a valuation based on “significant knowledge, experience, education or training.”  Section 409A defines “significant experience” to mean at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending or comparable experience in the company’s industry. This person does not need to be independent from the company. However, in order to rely on the illiquid startup insider valuation safe harbor:

ü  the company must have been conducting business for less than 10 years;

ü  the company may not have a class of securities that are traded on an established securities market;

ü  neither the company, nor the recipient of the option, “may reasonably anticipate” that the company will be acquired within 90 days or go public within 180 days; and

ü  the common stock must not be subject to put or call rights or other obligations to purchase such stock (other than a right of first refusal or a “lapse restriction,” such as the right of the company to repurchase unvested stock held by the employee at its original cost)

Restricted Stock as Alternative, Not Subject to 409A

Shares of restricted stock are not subject to Section 409A of the IRC. A recipient of shares of restricted stock may file an “election under Section 83(b) of the IRC to be taxed” in the year the election is made on the spread between the purchase price and the FMV as of the date of grant (typically nominal or zero) rather than being taxed, when the restriction on the shares lapses, on the spread between the purchase price and the FMV at the time of such lapses (when the shares are hopefully worth more).

Consequential Damages: Identification and Recovery of Lost Profits in NY

To recover "consequential" damages (defendant would argue that the damages sought by plaintiff are consequential), plaintiff must prove that (i) the damages sought by plaintiff were within the contemplation of the parties at the time of contracting as one of the remedies for the breach, (ii) the injury was actually caused by the breach, and (iii) the amount of the damages can be shown with reasonable certainty.

The very first argument by defendant would be that the type of injury alleged by plaintiff is consequential.

NY courts historically have had this bright-line rule that direct damages arise only where the lost profits were to be realized out of the transactions between the contracting parties under the contract.

In Biotronik, the highest court in NY stated that lost profits are direct damages when lost profits are natural and probable consequence of the breach under the contract. So, you cannot assume that lost profits are consequential damages.

In a reseller agreement, under which the reseller purchases products from the manufacturer, pays for the product transfer fee upon sale, and takes profits from the sale, lost profits of the reseller due to the manufacturer's recall of inventory were determined by the NY court to be direct damages because the contract would not work unless the reseller was engaged in the resale of the products (recall resulted in no resale, which resulted in lost profits).

A contract clause excluding "consequential damages" would not necessarily bar lost profits claims at least in NY.

One Rule: "Everyone is willing to give you something, ready to give you something. Whatever it is they are hungry for."

What is it that I am hungry for? Lying is a cooperative act. We are filling these gaps in our lives with lies. We are deeply ambivalent about the truth. And we don't understand the gaps in our lives. Freud said "no mortal can keep a secret." We all chatter with our fingertips.

• non-contracted denial (formal language - over-determined) - "did not"
• distancing language: "that woman"
• qualifying language: "in all candor"

Real smiles are in the eyes, not cheeks. We rehearse our words but not gestures. Withdrawn, looking down, pause, pepper it with way to much detail, in a very chronological order. Head shakes. They then get away with, known in the trade, duping delight. Making one expression, while masking another that is just leaking an expression of anger in a flash. 

Watch out for an expression of contempt. When anger turns into contempt, you are dismissed. It is associated with moral superiority. Marked by one lip corner pulled up and in. It is the only asymmetrical expression. In the presence of contempt, look the other way, go the other direction, reconsider the deal.

Shift their blink rate. Point their feet towards the exit. Take a barrier object and put it in front. Change and lower vocal tone. When you see a cluster of them, beware. Walk into that curiosity mode.

Stockholder Approval of Interested Party Transactions under DGCL 144

Here are certain sample recitals/stockholders resolutions that are useful in approving a charter amendment in compliance with Section 144 of DGCL to increase authorized capitalization of an issuer company in a subsequent round of a private placement transaction:

"WHEREAS, pursuant to Section 144 of the Delaware General Corporation Law, no contract or  transaction between the Company and any other corporation, partnership, association or other organization in which one or more of the officers or directors of the Company is an officer or director, or has a financial interest (any such contract or transaction is referred to herein as an “Interested Party Transaction”), shall be void or voidable solely for that reason, or solely because the director or officer is present at or participates in the meeting of the Board, at which the Board authorized the Interested Party Transaction or solely because the vote of any such director is counted for such purpose, if: (a) the material facts as to the relationship or interest and as to the contract or transaction are disclosed or are known to the Board, and the Board in good faith authorizes the contract or transaction by affirmative votes of a majority of the disinterested directors, even though the disinterested directors be less than a quorum, (b) the material facts as to the relationship or interest and as to the contract or transaction are disclosed or are known to the stockholders entitled to vote thereon, and the contract or transaction is specifically approved in good faith by the requisite vote of the stockholders, or (c) the contract or transaction is fair as to the Company as of the time it is authorized, approved or ratified by the Board or the stockholders;

WHEREAS, it is hereby disclosed or made known to the undersigned that:

• ___________, a director of the Company, is a principal of and has a financial interest in the _______________, L.P. and its affiliates (the “Existing Investor Entities”) and the Existing Investor Entities have expressed an interest in purchasing _________ shares of Company stock;
• [Or any other transactions that amount to Interested Party Transactions

NOW THEREFORE BE IT RESOLVED, that Company’s _____ Amended and Restated Certificate of Incorporation (the “Restated Certificate”) in substantially the form as set forth in Exhibit A hereto, is hereby approved and adopted in all respects.

RESOLVED FURTHER, that the Board may elect to abandon the financing and/or the Restated Certificate, before or after stockholder approval thereof, without further action by the stockholders at any time prior to the effectiveness of the Restated Certificate.

RESOLVED FURTHER, the foregoing resolutions may be executed in separate counterparts, each of which shall constitute an original, but all of which together shall constitute one and the same instrument."

And don't forget to obtain waivers from the existing investors/stockholders (certain qualified investors) regarding their right of first offer and notice requirements of the issuer company to purchase the pro rata share of the shares to be issued in the later rounds (most commonly found in NVCA styly Investors Rights Agreement).

Materiality Scrape

What is it?

A materiality scrape is a provision in an acquisition agreement that effectively eliminates, for indemnification purposes, any materiality qualifiers in a representation/warranty or covenant in determining (i) whether or not a breach has occurred, and/or (ii) the amount of indemnifiable losses resulting from that breach. When it is applied with the conjunctive word above, it is a double materiality scrape. With the disjunctive word above, it is a single materiality scrape, which is not uncommon.

The qualifiers most commonly subject to a scrape are "material," "materiality," and "material adverse effect." Less often seen is a "knowledge scrape," which eliminates knowledge qualifiers.

What is the point of inserting materiality qualifiers and then delete them or replace them with "any and all?"

Because the materiality scrape may eliminate SOME but NOT ALL effects/purposes of the materiality qualifiers, for example in the following contexts:

1. Singling out the question of whether closing conditions have been met and treating it differently one way (leave materiality qualifier) or the other (scrape materiality qualifier)
2. Fine-tuning the scope of seller disclosure schedule (e.g., disclose (only) all "material" contracts)
3. Determining whether a breach has occurred (e.g., compliance with all applicable laws in "all material respects")
4. Determining the losses resulting from a breach (e.g., seller's obligation to indemnify purchaser against only those losses above a "material amount"

Where to put it?

A materiality scrape provision is commonly found in the indemnification provisions or as a separate stand-alone provision.

Language

"The Seller shall indemnify, defend and hold harmless the Purchaser and its Affiliates and their respective employees, officers, directors, stockholders, partners and representatives from and against any losses, assessments, liabilities, claims, damages, costs and expenses (including reasonable attorneys’ fees and disbursements) incurred by such indemnified party as the result of any misrepresentation in, breach of or failure to comply with, any of the representations, warranties, covenants or agreements of the Seller contained in this Agreement, in each case, as each such representation, warranty, covenant or agreement would read if all qualifications as to knowledge or materiality, including each reference to the defined term “Material Adverse Effect,” were deleted therefrom."

"For purposes of determining whether there has been a breach and the amount of any losses that are the subject matter of a claim for indemnification, each representation and warranty in this Agreement will be read without regard and without giving effect to the term “material” or “material adverse effect” (fully as if any such word or phrase were deleted from such representation and warranty)."

Purchaser's Arguments For Scrape

1. To aggregate immaterial breaches and the losses resulting therefrom and count them toward the basket, that is, to eliminate the effect of "double materiality threshold." A typical acquisition agreement contains a basket, which is intended to provide the seller as the indemnifying party with protection from general indemnity claims below a certain negotiated amount, that is, immaterial claims. Without a materiality scrape, the buyer may incur many losses as a result of unrelated breaches of the seller's representations and warranties that are not individually material (not rising above the materiality threshold and not being treated as an indemnifiable loss) but are material in the aggregate, and therefore, such losses would not count toward the basket (because the basket contain only those indemnifiable losses), resulting in a double materiality threshold (such lossess not counting toward, and then what is in the basket not indemnified). Sometimes, an acquisition agreement may also include a "de minimis threshold" (a so-called mini-basket) (e.g., "an individual claim of less than $__ is not covered by indemnification (drop out from any calculation) and does not count towards the basket"), resulting in a triple materiality threshold.
2. To expand the applicability of a materiality scrape into calculating losses from determining whether a breach has occurred, and eliminate the uncertainty.

Another double materiality issue occurs when one of the closing conditions is tied to seller's representations and warranties being true in all material respect, and some of those representations and warranties may already have their own materiality qualifiers. To address this issue, a buyer would have to bifurcate the closing condition into two closing conditions: i) the reps and warranties that are not qualified by materiality qualifiers must be true and correct in all material respects, and ii) the reps and warranties that are qualified by materiality qualifiers must be true and correct in all respects.

Seller's Arguments Against Scrape

1. Being forced into a breach when the purchaser's use of the scrape was to distinquish the question of whether closing conditions have been met from the question of whether a breach has occurred, and leave materiality qualifier in the closing conditions but scrape materiality qualifier in the representations and warranties
2. Unreasonable risk allocation: nickeling and diming of the purchaser
3. Unreasonable disclosure burden (imagine a disclosure schedule setting forth all contracts (as compared to all "material" contracts) or responding to a representation that the seller has complied with all applicable laws (as compared to "all applicable laws in all material respects")
4. Drafting issues (seller representing that there has been no MAE since ____, F/S reps tied to GAAP standard that the F/S fairly present in all material respects the financial condition of the seller, reps tied to Rule 10b-5 language, that is, not containing any untrue statement of material fact or not omitting to state a material fact necessary to make any of the statements, in light of the circumstances in which they were made, not misleading, reps not tied to any basket)

Negotiation and Compromise

1. Seller may accept a scrape in exchange for the use of a true deductible basket where the basket amount is never recoverable and serves as a deductible against buyer claims) instead of a tipping basket where the basket amount is recoverable from dollar one once the aggregate buyer claims exceed the basket amount
2. Seller may accept a scrape in exchange for an increased basket amount
3. Specify the materiality threshold in each representation and warranty using a dollar threshold
4. Seller may want to have the scrape apply to the calculation of losses but not to the determination of whether a breach occurred (single scrape instead of double scrape)
5. Carve out disclosure obligations of the seller so it need not disclose immaterial matters on the schedules
6. Carve out F/S reps (GAAP standard) and reps that are not subject to materiality qualifiers

Section Section 4(1½) Exemption

Section 4(1½) exemption is a hybrid exemption developed through case law and SEC No-Action Letters that is commonly referred to as the “Section 4(1½) exemption” (referred to as such because such case law and No-Action Letters predated the revision to the Securities Act of 1933 (the "Act") pursuant to Section 201 of the Jumpstart Our Business Startups Act), under which a person purchasing securities from an issuer is not an underwriter for purposes of Section 4(a)(1) of the Act if such person resells the securities in transactions that would meet the exemption under Section 4(a)(2) of the Act so long as the purchaser did not originally purchase with a view to distribution.  The inquiry as to the availability of the Section 4(1½) exemption requires the analysis of the following factors:

1. Holding Period of Securities being Sold.  The longer the holding period, the greater the likelihood that the Section 4(1½) exemption applies.

2. Amount Sold.  Sales of large blocks of stock are permissible if the other requirements of the exemption are met.

3. Purchasers.  Each offeree should be sophisticated with respect to business and financial matters, as well as with respect to the particular investment being offered.  Also, the fewer the number of offerees, the greater the chance for an exemption.

4. Access to Information.  Each offeree should have access to the type of information that would be disclosed in a private placement memorandum.

5. Manner of Offering.  General solicitations and advertising should be avoided.

6. Restrictions on Resale.  The securities received by the purchasers should be restricted as to their transfer and should bear an appropriate legend reflecting this fact.

Section 4(a)(1) Exemption for an affiliated charity foundation

Section 4(a)(1) provides exemptions for transactions by any person other than an issuer, underwriter, or dealer.  Under the Act, a “dealer” means any person who engages for all or part of his time, directly or indirectly, as agent, broker, or principal, in the business of offering, buying, selling, or otherwise dealing or trading in securities issued by another person. A charitable foundation that is affiliated with an issuer (the "Foundation"), when trying to offer and sell shares of the issuer it received from the issuer, is not a dealer because it does not engage in the business of offering, buying, selling, or otherwise dealing or trading in securities issued by another person and is unlikely to be considered the “issuer” in the offering.  As a result, whether the Section 4(a)(1) exemption is available for the such offering turns on the question of whether the Foundation is considered an “underwriter.” Under the Securities Act of 1933, an “underwriter” means any person who (i) has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, (ii) participates or has a direct or indirect participation in any such undertaking, or (iii) participates or has a participation in the direct or indirect underwriting of any such undertaking.  The longer the Foundation has held such shares the less it is likely that the Foundation is considered to have had the intent to distribute the shares when it acquired those shares. The question then, is whether the Foundation is participating “in any such undertaking.”  One can argue that this language refers to an undertaking involving the purchase of shares from an issuer with a view to distribution.

Rule 701 Exemption in a Nutshell

Rule 701 of the Securities Act of 1933, as amended (the “Act”), exempts offers and sales of securities pursuant to a written compensatory benefit plan or a written compensation contract established by an issuer for the participation of its employees, directors, general partners, trustees (where the issuer is a business trust), officers, or consultants and advisors, and their family members who acquire such securities from such persons through gifts or domestic relations orders. 

Rule 701 also exempts offers and sales to former employees, directors, officers, consultants and advisors but only if such persons were employed by or providing services to the issuer at the time the securities were offered.  

A “compensatory benefit plan” is any purchase, savings, option, bonus, stock appreciation, profit sharing, thrift, incentive, deferred compensation, pension or similar plan.  A stock-based plan established for employees is generally considered “compensatory” if it is not used as a capital raising device.

The issuer should be aware of the limitation on aggregate sales price of securities that may be sold in reliance on Rule 701 during any consecutive 12-month period.  That limit is the greatest of the following:

1. $1,000,000
2. 15 percent of the total assets of the issuer measured at the issuer’s most recent annual balance sheet date (if no older than its last fiscal year-end); or
3. 15 percent of the outstanding amount of the class of securities being offered and sold in reliance on Rule 701, measured at the issuer’s most recent annual balance sheet date (if no older than its last fiscal year-end).  For this purpose, different classes of stock of the employer may be aggregated in certain circumstances.

Amounts of securities sold in reliance on Rule 701 do not affect “aggregate offering prices” in other exemptions, and amounts of securities sold in reliance on other exemptions do not affect the amount that may be sold in reliance on Rule 701.

The issuer must deliver to investors a copy of the compensatory benefit plan or the contract, as applicable. In addition, if the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $5 million, the issuer must deliver certain additional disclosure to investors a reasonable period of time before the date of sale, including certain financial statements of the issuer.

Offers and sales exempt under Rule 701 are deemed to be a part of a single, discrete offering and are not subject to integration with any other offers or sales, whether registered under the Act or otherwise exempt from the registration requirements of the Act.

Securities issued under Rule 701 are deemed to be “restricted securities” as defined in Rule 144 and resales of such securities must be in compliance with the registration requirements of the Act or an exemption from those requirements. Ninety days after the issuer becomes subject to the reporting requirements of section 13 or 15(d) of the Exchange Act, securities issued under Rule 701 may be resold by persons who are not affiliates in reliance on Rule 144, without compliance with paragraphs (c) and (d) of Rule 144, and by affiliates without compliance with paragraph (d) of Rule 144.

Business Acquisition and Item 2.01 on Form 8-K Disclosure

Form 8-K Item 2.01 requires certain disclosure “if the registrant or any of its majority-owned subsidiaries has completed the acquisition or disposition of a significant amount of assets, otherwise than in the ordinary course of business.” This requirement on its face only refers “a significant amount of assets,” as the basis of the triggering event, but instruction 4 thereto further elaborates that the disclosure requirement is triggered under either one of the two circumstances:

"Instruction 4. An acquisition or disposition shall be deemed to involve a significant amount of assets:

(i) if the registrant’s and its other subsidiaries’ equity in the net book value of such assets or the amount paid or received for the assets upon such acquisition or disposition exceeded 10% of the total assets of the registrant and its consolidated subsidiaries; or

(ii) if it involved a business (see 17 CFR 210.11-01(d)) that is significant (see 17 CFR 210.11-01(b))."

(i) above talks about “assets (hereinafter referred to as the “asset test”),” but interestingly, (ii) above introduces the term, “business,” with references to Reg. S-X sections (hereinafter referred to as the “business test”).

Reg. S-K 11-01(d) explains the meaning of “business” to be considered under our Item 2.01 test:

"(d) For purposes of this rule, the term business should be evaluated in light of the facts and circumstances involved and whether there is sufficient continuity of the acquired entity's operations prior to and after the transactions so that disclosure of prior financial information is material to an understanding of future operations. A presumption exists that a separate entity, a subsidiary, or a division is a business. However, a lesser component of an entity may also constitute a business. Among the facts and circumstances which should be considered in evaluating whether an acquisition of a lesser component of an entity constitutes a business are the following:

(1) Whether the nature of the revenue-producing activity of the component will remain generally the same as before the transaction; or

(2) Whether any of the following attributes remain with the component after the transaction:

(i) Physical facilities,

(ii) Employee base,

(iii) Market distribution system,

(iv) Sales force,

(v) Customer base,

(vi) Operating rights,

(vii) Production techniques, or

(viii) Trade names."

Once one concludes whether the transaction contemplated is considered a transaction involving a business as defined by Reg. S-X 11-01(d), then one should analyze whether such business is considered “significant” under Reg. S-X 11-01(b).

Reg. S-K 11-01 (b) provides “a business combination or disposition of a business shall be considered significant if:

(1) A comparison of the most recent annual financial statements of the “business acquired or to be acquired” and the registrant's most recent annual consolidated financial statements filed at or prior to the date of acquisition indicates that the business would be a significant subsidiary pursuant to the conditions specified in §210.1-02(w), substituting 20 percent for 10 percent each place it appears therein; or

(2) The business to be disposed of meets the conditions of a significant subsidiary in §210.1-02(w).”

Reg. S-K 1-02(w) further provides the meaning of “significant subsidiary.” The term significant subsidiary means a subsidiary, including its subsidiaries, which meets any of the following conditions:

(1) The registrant's and its other subsidiaries' investments in and advances to the subsidiary exceed 10 percent of the total assets of the registrant and its subsidiaries consolidated as of the end of the most recently completed fiscal year (for a proposed combination between entities under common control, this condition is also met when the number of common shares exchanged or to be exchanged by the registrant exceeds 10 percent of its total common shares outstanding at the date the combination is initiated); or

(2) The registrant's and its other subsidiaries' proportionate share of the total assets (after intercompany eliminations) of the subsidiary exceeds 10 percent of the total assets of the registrants and its subsidiaries consolidated as of the end of the most recently completed fiscal year; or

(3) The registrant's and its other subsidiaries' equity in the income from continuing operations before income taxes, extraordinary items and cumulative effect of a change in accounting principle of the subsidiary exclusive of amounts attributable to any noncontrolling interests exceeds 10 percent of such income of the registrant and its subsidiaries consolidated for the most recently completed fiscal year.

Note to paragraph (w): A registrant that files its financial statements in accordance with or provides a reconciliation to U.S. Generally Accepted Accounting Principles shall make the prescribed tests using amounts determined under U.S. Generally Accepted Accounting Principles. A foreign private issuer that files its financial statements in accordance with IFRS as issued by the IASB shall make the prescribed tests using amounts determined under IFRS as issued by the IASB.

Interestingly, the Financial Reporting Manual seems to contradict Form 8-K Item 2.01 or the instruction thereto:

2040.1 of the Financial Reporting Manual with respect to Form 8-K Item 2.01 states “a) Item 2.01, Form 8-K reporting the transaction is required within 4 business days of the consummation of any business acquisition exceeding 20% significance or for any asset purchase exceeding 10% significance that does not meet the definition of a business.”

...
c) If the required financial statements of the business acquired are not required to be provided with the initial report, they must be filed by amendment within 71 calendar days after the date that the initial report on Form 8-K must be filed.

NOTE: While an Item 2.01 Form 8-K is not required for business acquisitions at or below 20% significance, registrants may elect to report business acquisitions at or below 20% significance pursuant to Item 8.01 of Form 8-K even if financial information is not provided."

Both the Office of Chief Accountant and the Office of Chief Counsel at CorpFin of SEC confirmed that this Note is the interpretation of Item 2.01 requirement by both offices as of June 2016.

Sandbagging and Anti-sandbagging

Sandbagging?

In the context of a U.S. business acquisition, “sandbagging” typically refers to a situation in which the buyer is or becomes aware (through its own diligence or superior knowledge, either as of signing or between signing and closing) that a specific representation and warranty by the seller in the acquisition agreement is untrue, signs and/or closes the transaction despite the knowledge, and then seeks to hold the seller liable for such breach post closing. (from M & A Lawyer Jan. 2007).

A “sandbagging” or "knowledge savings" provision (sometimes referred to as a “pro-sandbagging” provision) in a mergers and acquisition agreement (asset purchase agreement, stock purchase agreement, or merger agreement) states that a buyer’s remedies against the seller under the agreement will not be impacted by whether or not the buyer had knowledge, prior to closing the deal, of the facts or circumstances giving rise to the claim. In other words, even if the buyer knew of the problem at hand―whether it be the company’s non-compliance with applicable laws, a breach of a customer contract, or other breach of a representation, warranty or covenant―it could decide to complete the acquisition with that knowledge, and then proceed against―or “sandbag”―the seller for recourse under the agreement. Reasons for sandbagging include i) it may be unclear to Purchaser whether a breach occurred, ii) the materiality of such breach may be unclear to the Purchaser, iii) the right of Purchaser to treat such breach as an unfulfilled condition to closing may be unclear, iv) Seller may have tried to do information dumping in its disclosure schedule at the 11th hour, or v) Seller may have already made it clear its unwillingness to a purchase price adjustment for such breach, etc. A Purchaser's options include termination, price adjustment (concession from the Seller) or close the transaction and seek indemnification to enforce the benefit of the bargain it negotiated with the Seller.

An “anti-sandbagging” clause prohibits the buyer from “sandbagging” the seller, by contractually limiting the buyer’s ability to seek recourse with respect to matters which the buyer knew about at or prior to closing (from Bloomberg Law Reports).

Language

A typical pro-sandbagging provision could read as follows:

"The rights of the Purchaser to indemnification or any other remedy under this Agreement shall not be affected, limited or deemed waived by reason of any knowledge that the Purchaser may have acquired, could have acquired or should have acquired, whether before or after the closing date, nor by reason of any investigation made (or not made) or diligence exercised (or not exercised) by any of the Purchaser, or its advisors, agents, consultants or representatives. The Seller hereby acknowledges that, regardless of any investigation made (or not made) by or on behalf of the Purchaser, and regardless of the results of any such investigation, the Purchaser has entered into this transaction in express reliance upon the representations and warranties of the Seller made in this Agreement. The Seller further acknowledges that, in connection with this transaction, the Purchaser has furnished to the Seller good and sufficient consideration in exchange for the Seller’s representations and warranties made herein."

Another example of knowledge savings clause is:

"No Waiver of Contractual Representations and Warranties — Seller has agreed that Buyer’s rights to indemnification for the express representations and warranties set forth herein are part of the basis of the bargain contemplated by this Agreement; and Buyer’s rights to indemnification shall not be affected or waived by virtue of (and Buyer shall be deemed to have relied upon the express representations and warranties set forth herein notwithstanding) any knowledge on the part of Buyer of any untruth of any such representation or warranty of Seller expressly set forth in this Agreement, regardless of whether such knowledge was obtained through Buyer’s own investigation or through disclosure by Seller or another person, and regardless of whether such knowledge was obtained before or after the execution and delivery of this Agreement."

A typical anti-sandbagging provision could read as follows:

"The Purchaser acknowledges that it has had the opportunity to conduct due diligence and investigation with respect to the Seller, and in no event shall the Seller have any liability to the Purchaser with respect to a breach of representation, warranty or covenant under this Agreement to the extent that the Purchaser knew of such breach as of the Closing Date. The Purchaser further acknowledges that, to the extent the Purchaser, or any of the Purchaser's advisors, agents, consultants or representatives, by reason of such due diligence and investigation, whether or not undertaken, knew, could have or should have known that any representation and warranty made herein by the Seller is or might be inaccurate or untrue, this constitutes a release and waiver of any and all actions, claims, suits, damages or rights to indemnity, at law or in equity, against the Seller by the Purchaser arising out of breach of that representation and warranty. Nothing herein shall be deemed to limit or waive the Purchaser's rights against the Seller arising out of any other representation and warranty made herein by the Seller."

Another example is:

"Effect of Buyer’s Knowledge — Notwithstanding anything contained herein to the contrary, Seller shall not have (a) any liability for any breach of or inaccuracy in any representation or warranty made by Seller to the extent that Buyer, any of its Affiliates or any of its or their respective officers, employees, counsel or other representatives (i) had knowledge at or before the Closing of the facts as a result of which such representation or warranty was breached or inaccurate or (ii) was provided access to, at or before the Closing, a document disclosing such facts; or (b) any liability after the Closing for any breach of or failure to perform before the Closing any covenant or obligation of Seller to the extent that Buyer, of its Affiliates or any of its or their respective officers, employees, counsel or other representatives (i) had knowledge at or before the Closing of such breach or failure or (ii) was provided access to, at or before the Closing, a document disclosing such breach or failure."

Sandbagging is usually not applicable to (i) a transaction where the Company/Seller is a public company because the representations and warranties typically terminate at the closing of the transaction (Survival Clause issue), or (ii) the Purchaser's breach of its representations and warranties to the extent the Buyer pays the negotiated price under the transaction agreement. Therefore, sandbagging has a significant implication in the negotiation of private equity acquisition agreements.

Choice of Law

• Minnesota (Seller-friendly): If a Purchaser acquires knowledge of a breach from any source before the closing, the Purchaser waives its right to sue. To prove a misrepresentation, the Purchaser must prove it relied on the misrepresentation. (Hendricks v. Callahan, 8th Cir. 1992) (Burden of Proof on Purchaser regarding Knowledge; Fraud Exception; Makes Sense in Management or Insider Buy-Out)
• Delaware: A Purchaser can sandbag unless an anti-sandbagging provision is in the agreement. Where the agreement is silent, the Seller’s representations and warranties are unaffected by the Purchaser's due diligence. (Interim Healthcare, Inc. v. Spherion Corp., Del Super. Ct. 2005)
• New York (Purchaser-friendly): The court will review whether the Purchaser believed that it was purchasing the Seller’s promise to indemnify the Purchaser should a particular representation and warranty of the Seller turns out to be untrue. (CBS Inc. v. Ziff-Davis Publishing Co.,  N.Y. 1990) The court will also examine whether the Purchaser waived its rights to sue on the known breach or not---the Purchaser should specifically preserve its rights to so sue prior to closing. (Carefully-Negotiated Indemnification Package issue; Unqualified Reps and Warranties; Reps and Warranties Should Not Merge with Sale of Assets).

Origin of the Contortion of Tort-based Cause of Action and Contract-based Cause of Action

• Tort Theory Behind Seller's Story - A tort claim is extra-contractual, meaning it is based not on a bargain between parties, but on a wrongful act committed by another that resulted in injury to the claimant. In commercial relationships, that wrongful act is typically an intentional, reckless or negligent misrepresentation of fact intended to induce the claimant to act in a manner detrimental to such person. Reliance by the claimant has always been an element of a tort claim for fraud based on intentional or reckless misrepresentation of fact. Note that courts historically considered mere "representations" as mere affirmations of fact (as inducements) and not as promises or the equivalent of promises. Therefore, the introduction of warranties, as contractual promises that the stated facts are true occurred in modern U.S. practice. Note that in most U.K. acquisition agreements only warranties appear without the representations.
• Contractual Claim by Purchaser - The court should enforce the expectations of the parties according to the bargain made by the parties. Offer, acceptance and an exchange of consideration. A claim for breach of contract requires ONLY that the claimant prove that i) the other party to the agreement failed to perform its promises pursuant to the bargain made by the parties, the contract and ii) the claimant incurred damages. There is no such concept as "reliance by the claimant" in breach of contract claims. In modern U.S. practice, contractual indemnification is provided explicitly for breaches of representations and warranties as well as for specifically identified matters for which a bargained-for special indemnity has been given. Both kinds of indemnifiable matters are all expressly made a part of contract and subject to the exclusive contractual remedies provided in the contract.

Buyers Beware

1. Whenever possible, resist an "anti-sandbagging"clause and insert "knowledge savings/anti-anti sandbagging" clause
2. Choose governing law carefully; do not assume that a knowledge savings clause will protect the buyer automatically (e.g., no reliance argument in MN)
3. Carve out special issues and cover them under a special indemnity provision
4. Broadly exclude "fraud" from an exclusive remedies provision
5. If forced to allow anti-anti sandbagging provision, limit the standard of proof to "actual" knowledge of a fixed number of identified persons, and exclude constructive, implied or imputed knowledge (advisors' or attorneys' knowledge)
6. Have Seller update disclosure schedules at the time of closing (allowing Buyer to walk away upon such update)