California Lawyers Association
Ethics Spotlight: Conflicts of Interest in M&A Transactions
By Neil J Wertlieb
This article addresses certain unique conflict of interest issues that arise in connection with the sale of a business.
The Structure of a Sale Transaction
The sale of a business is typically structured in one of three ways: (1) the entity that owns the business sells its assets to a buyer; (2) the equity owners of that entity sell their equity interests to a buyer; or (3) the entity is merged with the buyer (or more typically a subsidiary of the buyer). If you are the lawyer for a corporation working on the sell-side of such a transaction, it is not always clear whose interests you are engaged to protect when it is your client that is being sold.
In an asset sale, there is little question that the corporation that owns the assets is the party to the transaction, selling its assets to the buyer. As corporate counsel, your role in the transaction is not in dispute—you are working to protect the interests of your client, the seller of the assets. While the corporation’s shareholders might be required to approve the corporation’s sale of substantially all its assets, since they are not selling anything they typically are not parties to the sale transaction.
In a sale by merger, the corporation is also a party to the transaction, agreeing to merge with the buyer (or its subsidiary). Similar to an asset sale, as corporate counsel, your role in the transaction is to act as counsel to the corporation in its capacity as a party to the transaction. And again, while the corporation’s shareholders are required to approve the merger, and their shares in the corporation will be converted into the right to receive the merger consideration, they typically are not parties to the merger transaction.
But in a stock sale, it is the corporation’s shareholders who are selling the business directly by selling their shares in the corporation to the buyer, and the corporation itself typically would not even be a party to the transaction. In this instance, your role as corporate counsel is particularly elusive, especially if your client is not even a party to the transaction.
Conflicts of Interest in Connection with the Sale Transaction
When working on the sell-side of any of the foregoing transactions, corporate counsel needs to have a clear understanding of who the client is, and who the client is not, and where appropriate should communicate such distinction to non-client participants who might reasonably believe that they are clients. See Responsible Citizens v. Superior Court (Askins) (1993) 16 Cal.App.4th 1717 (“one of the most important facts involved in finding an attorney-client relationship is the expectation of the client based on how the situation appears to a reasonable person in the client’s position.”). See, also, Rule 1.13(f) of the California Rules of Professional Conduct (“In dealing with an organization’s constituents, a lawyer representing the organization shall explain the identity of the lawyer’s client whenever the lawyer knows or reasonably should know that the organization’s interests are adverse to those of the constituent(s) with whom the lawyer is dealing.”).
Generally, corporate counsel need not provide such a disclaimer to the shareholders of a corporation engaged in an asset sale or a merger, because the structure of the transaction unequivocally signals that the corporation itself, as the party to the transaction, is the client. Of course, there are exceptions to this general proposition, such as when corporate counsel is asked by one or more shareholders to review on their behalf a non-compete or other agreement that they are expected to sign as part of the sale transaction. However, absent such exceptional circumstances, the shareholders are not clients of the corporation’s lawyer. See Rule 1.13(a) (“A lawyer employed or retained by an organization shall conform his or her representation to the concept that the client is the organization itself”).
Corporate counsel is often engaged before the ultimate structure of the transaction has been agreed upon by the parties. In fact, advising on the optimal acquisition structure may be part of the responsibility of the lawyer engaged by a corporation whose business is being acquired. For example, when corporate counsel is initially engaged to work on the sale, the intended deal structure might be an asset sale or a merger. However, at some point during the negotiations, the structure could change to a stock sale. Such a change could be the result of tax benefits to one or more parties to the transaction, to address regulatory or third-party constraints, or for other reasons.
Once corporate counsel becomes aware that the transaction will likely be structured as a stock sale, they need to consider what their role is in the transaction. As lawyer to the corporation, if the corporation itself is not a party to the transaction, query what role corporate counsel (as such) has with respect to the transaction—if any. If the shareholders of the corporation are the parties to the transaction, they presumably need to be represented by competent legal counsel who will advise them with respect to, among other things, their rights and obligations under the stock purchase agreement.
It is certainly possible that corporate counsel in such a situation could represent the selling shareholders in addition to (or in place of) the corporation. See Rule 1.13(g) (“A lawyer representing an organization may also represent any of its constituents, subject to the provisions of rules 1.7 [Conflict of Interest: Current Clients] ….”). However, in order to do so, corporate counsel would need to properly onboard the shareholders as clients, including conducting conflict checks and procuring conflict waivers as may be required. Corporate counsel would need to identify and address any potential conflicts that might arise due to the concurrent representation of the selling shareholders on the one hand, and the corporation on the other hand.
Further, if the interests of the various shareholders differ in the sale transaction, there may be conflicts among the selling shareholders as well. This could arise, for example, if there are different classes of equity, such that the purchase price might be allocated differently to different shareholders. This could also arise if one or more of the selling shareholders are employees of the corporation, and are separately negotiating their continued employment following the change in ownership of the corporation. Similarly, some of the selling shareholders may be required by the buyer to enter into agreements not to compete with the business following the sale, and a portion of the total consideration for the sale might be allocated to only those shareholders as compensation for their non-compete agreements.
Such conflicts require that the corporate counsel carefully review their obligations under Rule 1.7 of the California Rules of Professional Conduct, including paragraph (a) (“A lawyer shall not, without informed written consent from each client …, represent a client if the representation is directly adverse to another client in the same or a separate matter”) and paragraph (b) (“A lawyer shall not, without informed written consent from each affected client …, represent a client if there is a significant risk the lawyer’s representation of the client will be materially limited by the lawyer’s responsibilities to or relationships with another client ….”). See, also, Flatt v. Superior Court (1994) 9 Cal.4th 275.
Conflicts of Interest Following the Sale Transaction
The obligation to carefully monitor conflicts and the identity of the client does not end upon the closing of the sale transaction. Corporate counsel working on a sale transaction may also be involved in certain post-closing matters relating to the transaction. Such matters often include post-closing purchase price adjustments (including earn-outs), indemnification claims, and transitional support agreements. Such post-closing work is normally done on behalf of the seller—whether it’s the corporation if structured as an asset sale or, if structured as a stock sale, the selling shareholders who may have contractual rights or obligations following the closing of the sale.
In addition, long-standing corporate counsel is often retained by the buyer to continue providing legal services to the business following the sale transaction, especially in matters unrelated to the sale. Such a post-closing engagement could happen regardless of the form of transaction. If the transaction was structured as an asset sale, because the business is now held within a different entity, corporate counsel would actually be taking on a new client despite continuing to work with the same business. As a result, corporate counsel would need to properly onboard the buyer as a client, including doing standard conflict checks (and procuring conflict waivers as may be required).
If the transaction was structured as a stock sale, corporate counsel may simply be continuing their attorney-client relationship with the corporation. However, if they were additionally representing the selling shareholders in the transaction, that would further complicate the conflict analysis with respect to any post-closing work that they may be doing on behalf of the selling shareholders.
These issues further highlight the need to properly identify who is, and who is not, the client or clients in connection with, and following, a sale transaction. Corporate counsel may find they are conflicted due to the concurrent representation of both the seller(s) and the buyer following the closing—which implicates Rule 1.7. And, even absent a concurrent representation, corporate counsel may find they are conflicted as a result of being adverse to a former client. This could arise if they continue as, or become, counsel to the business post-sale, and are tasked with some responsibilities in connection with the sale transaction, adverse to the former client seller(s)—which implicates Rule 1.9 (Duties to Former Clients) of the California Rules of Professional Conduct, including paragraph (a) (“A lawyer who has formerly represented a client in a matter shall not thereafter represent another person in the same or a substantially related matter in which that person’s interests are materially adverse to the interests of the former client unless the former client gives informed written consent.”).
Working on sale transactions raises some unique conflict of interest issues that sell-side M&A attorneys may need to address. These include properly identifying the parties to the transaction and whether or not the attorney is representing any of them—not only during the sale transaction itself, but also following the closing of the transaction whereby the client or its business has changed ownership.
Neil J Wertlieb is a Founding Member and Inaugural Co-Chair of the California Lawyers Association Ethics Committee, and a former Chair of the Business Law Section and its Corporations and Business Litigation Committees. Mr. Wertlieb is a transactional lawyer, educator and ethicist, who provides expert witness services in disputes involving business transactions and corporate governance, and in cases involving attorney malpractice and attorney ethics. For additional information, please visit www.WertliebLaw.com. The views expressed herein are his own.