Reducing Litigation Risk in M&A Transactions and Regulatory Compliance

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Litigation rarely occurs in a vacuum. While no one has a crystal ball, and no in-house counsel can correctly predict every future dispute, examining litigation trends and data can help companies and their legal departments identify and avoid many risks when engaging in M&A transactions or regulatory compliance activities.

But like most things in business and in life, you only get out of risk assessment what you put into it. Risk mitigation in M&A or regulatory compliance must be proactive and done on the front end, rather than as an afterthought, to unlock its full benefits.

In consumer financial services litigation, a problem impacting one borrower often has or will impact many other borrowers, so studying those trends and developments can pay dividends for in-house counsel.

Risk Assessment Impacts Strategic Decisions

Analyzing litigation risks can help companies in M&A transactions to identify potential legal risks, particularly when performed during the due diligence stage. The goal is to uncover any legal liabilities that could affect the transaction or create reputational or financial risk to the company after the transaction.

After a banner year for global M&A in 2022, transactional activity slowed considerably in 2023, in large part due to a disparity in target valuations among buyers and sellers, rising interest rates, the uncertainty of a potential recession and the geopolitical instability—the war in Ukraine, turmoil in the Middle East, and growing tensions between China and the West. Some observers feel this cooling climate for transactions has made disputes more likely. A recent In-House Community article noted that disputes related to material adverse change (MAC) clauses, earn-outs/deferred compensation, and post-closing price adjustments are happening with increased frequency.

Given changes in market uncertainty and potential disputes, pre-transaction due diligence has become even more critical to avoiding risk. Due diligence should include, among other things, reviewing all of the target company's legal documents, financials and tax documents, contracts, employment records and policies, intellectual property, data privacy and cyber security policies, insurance policies, and any potential liabilities. In-house attorneys also should pay close attention to any existing litigation (which may be actual or threatened) and the target company’s regulatory compliance history.

Once you have identified the possible risks in an M&A transaction, such as pending litigation or a regulatory consent order, what do you do with that information?

In-house counsel need to look 10 steps ahead and understand where the risk ultimately could take their company.

Forward thinking is the key. In-house counsel need to look 10 steps ahead and understand where the risk ultimately could take their company. For example, in consumer financial services, companies that went through a consent order to resolve an issue with a federal or state regulator often find themselves in litigation from consumers over the same issue, and vice versa.

The critical question is, “Are there protections you can implement ahead of time to prevent or mitigate those risks?” Such steps likely include requiring the target to cure the issue prior to closing (if possible) or negotiating special indemnities, escrows, reserves and holdbacks in the definitive purchase documents. For transactions where representations and warranties insurance is included, the underwriter will typically exclude any known or potential litigation risk from the policy, which means the investor/buyer will be exposed without further contractual obligations from the target/sellers. To the extent the magnitude of the litigation risk is significant, this may inform whether or not the transaction itself can move forward.

Regulatory Compliance and Risk Assessment

The perspective of seeing problems through a litigation lens can guide clients through the regulatory maze in compliance matters, in addition to M&A transactions. In-house attorneys may not be able to prevent an initial lawsuit, but they can prevent the next lawsuit by understanding the problem and helping to get it fixed proactively to avoid non-compliance in the future. In today’s regulatory climate, companies looking to engage in M&A activity should understand the regulatory issues underlying a potential transaction or ongoing at a target company, such as potential antitrust implications, industry-specific regulations and authorizations, WARN Act considerations, consumer protection concerns, applicable foreign regulatory regimes and/or simply understanding how changes to an existing practice may result in noncompliance with an existing law or regulation. Because laws and regulations change, it is important to continually stay on top of these updates and not rely on past research and analysis.

The perspective of seeing problems through a litigation lens can guide clients through the regulatory maze in compliance matters, in addition to M&A transactions.

Most regulatory problems are the flip side of the same coin as issues that arise in litigation. The stakeholders are different, but it is possible to resolve a complex regulatory matter in a way that will prevent litigation down the road. Further, being able to issue spot regulatory compliance red flags in a potential target may also inform whether additional disclosures or protections are required in the definitive purchase documents.

Precision in Drafting Key to Avoiding M&A, Compliance Disputes

Once risks have been identified, drafting certain provisions in M&A contracts is a key step in mitigating risks and avoiding inappropriate risk shifting from the seller to the buyer.

In-house attorneys should take care to avoid ambiguities in contracts and compliance policies that could lead to disputes. Be sure to provide clarity around price adjustments, earn-outs, indemnities, and closing conditions. Clearly outline the rights and obligations of all parties and define material terms and include comprehensive definitions sections.

A well-drafted M&A contract also includes detailed representations and warranties that disclose the facts about the businesses involved. The representations and warranties together with the disclosure schedules, need to accurately reflect the state of the target company, thereby minimizing the risk of unknown issues and claims for breach following the transaction.

Corporate legal teams also should add in proactive measures, including detailed covenants and indemnification provisions, to counter how a litigation may attack the policies or transaction documents down the road.

Indemnification clauses are essential for allocating risk between the buyer and the seller for post-closing liabilities. Such provisions should be drafted to clearly explain indemnification procedures, responsibility for losses, caps, baskets, survival periods, mitigation requirements, and exclusions.

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Thinking Ahead to Dispute Resolution

Understanding the mechanics of dispute resolution enables a company to structure M&A agreements with effective dispute resolution mechanisms, potentially avoiding costly litigation down the road.

For example, a contract can specify the use of mediation or arbitration before resorting to court proceedings. These can be more efficient, less costly alternatives to going to court.

Well-defined pre-closing covenants also an address actions both parties must take or refrain from taking prior to the closing of the transaction in a non-simultaneous sign and close transaction. Similarly, post-closing covenants may address which party controls an ongoing litigation and/or who is entitled to consent to a settlement. Such covenants can help address conflicts and confusion that can contribute to litigation.

In-house attorneys should communicate with key stakeholders at their company to make sure the contract drafted aligns with their business goals, risk appetite, and expectations.

M&A contracts and regulatory compliance activities are a necessary and beneficial part of normal business operations. But they also are rife with litigation risks. In-house counsel can play an essential role to their companies by understanding litigation trends, identifying possible risks, and mitigating those issues before they become major problems.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Attorney Advertising.

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