There’s a tongue-in-cheek joke within the legal industry that transactional lawyers create the problems, and the litigators get paid to clean them up. It’s a cautionary reminder to transactional lawyers: if the dealmaking process is not precise (or well-documented), then the risk of post-closing litigation is increased. In this second installment of PilieroMazza’s blog series, “Managing Litigation Risk During the Business Lifecycle,” we explore how a company acquiring another company can minimize litigation risk by taking a methodical and thoughtful approach during the business acquisition and post-closing stages. Visit this link to access Part 1 in this blog series.
A. Comprehensive Due Diligence
Due diligence is essential to mitigating litigation risks, as this process provides an opportunity for the buyer to identify and address any potential red flags that could lead to a costly dispute down the road. It is in the best interest of the buyer to begin due diligence in the early stages of a transaction, as this process often shapes the dealmaking process and allows the buyer to make an informed decision about its intended target (or targets). Although due diligence is typically spearheaded by the buyer’s corporate counsel, specialists play a key role in this process, providing important insights into matters such as litigation, tax, benefits, labor and employment, finance, environmental, intellectual property, cybersecurity, and regulatory compliance (especially for transactions involving government contractors).
As a buyer, it should be a high priority to ask pointed questions to the seller from the outset, so the seller can sufficiently respond to these requests and provide the answers that the buyer is seeking. Accordingly, this process usually begins with a comprehensive due diligence request list and may lead to supplemental requests further along in the process, depending on the review of documents along the way. Whether one is on the buy-side or sell-side of a transaction, due diligence tends to move more smoothly where there is an open line of communication and transparency between the buyer, seller, and their respective counsel. Oftentimes, the parties find it in their best mutual interest to hold a management call, which is an efficient way for a buyer and buyer’s counsel to ask questions in real-time and contextualize documents that the seller may have otherwise provided.
Once the buyer’s counsel determines that the responses from the seller are satisfactory, the next step in the process is typically to produce a memorandum for the buyer’s review. If a deal involves representations and warranties insurance, this is typically a requirement for insurers to back a transaction. The purpose of a due diligence memorandum is to provide key background information regarding a target and identify any red flags with a lens towards disputes that could arise at a later stage. Ultimately, the contents of the due diligence memorandum may guide the drafting of core and ancillary transaction documents, as discussed in the next section.
While thorough due diligence serves as a critical tool to uncover potential liabilities, its absence—or inadequacy—can open the door to a host of post-closing legal challenges. Buyers who rush through or limit the scope of their due diligence may later find themselves blindsided by issues that could have been anticipated and addressed prior to closing. Common consequences of an incomplete diligence process include:
- Unanticipated Liabilities: These may take the form of unresolved litigation, tax exposures, regulatory violations, or uncollectible receivables—any of which could undermine the value of the transaction or erode post-closing profitability
- Increased Litigation Exposure Post-Closing: Without proper vetting of contracts, employee claims, environmental risks, or intellectual property rights, the buyer may assume legal risk without recourse against the seller, leading to costly and disruptive disputes.
B. Precise Contractual Drafting
Even the most robust due diligence effort cannot substitute for well-drafted acquisition documents. Precision and clarity in the transaction documents—especially the purchase agreement—are indispensable in allocating risk, setting expectations, and avoiding future disputes.
- Key Provisions Requiring Particular Attention
- Indemnification Clauses: These provisions allocate responsibility in the event of a breach or third-party claim. Careful attention should be paid to caps on liability, baskets, survival periods, and procedures for asserting claims.
- Earn-Out and Purchase Price Adjustment Mechanisms: These provisions are often points of contention post-closing, especially if financial metrics are not clearly defined. The parties should spell out calculation methodologies, dispute resolution processes, and access to records clearly in the purchase agreement.
- Conditions for Closing, Including Material Adverse Change (MAC) Clauses: These clauses define events that could excuse a party from closing the transaction. Precision in defining what qualifies as a MAC can reduce the risk of litigation if unforeseen market or business conditions arise.
- Clearly Defined Termination Conditions: To avoid disputes over whether a party had the right to exit the transaction, termination rights and procedures must be clear, with built-in notice and cure periods, where appropriate.
- Risks Associated with Ambiguous or Vague Contractual Language
In the absence of specific terms, parties may resort to litigation to argue over intent or meaning—often at great cost and business disruption. Litigation over unclear earn-out provisions, disputed working capital adjustments, or vague indemnification rights is common. Engaging experienced counsel during the drafting stage is essential to ensure contractual clarity and legal enforceability.
C. Robust Representations and Warranties; Disclosure Schedules
While due diligence and the drafting of the core deal documents commonly occur simultaneously, the findings from the due diligence process often shape the eventual agreement. Namely, the representations and warranties section of a purchase agreement allows the buyer to shed light on any red flags that were brought to its attention through the due diligence process. It requires the seller to make formal statements about its business and reveal issues prior to closing, thus reducing the chance of any post-closing surprises that could lead to a lawsuit. If the parties have identified potential (or, at times, imminent) legal issues, this section establishes liability and sets forth certain conditions, which provide clarity as to how the parties should resolve a dispute.
The disclosure schedules play a critical role in mitigating litigation risks because they serve as the fine print that qualifies the representations and warranties, as discussed above. Initially drafted by the seller and later reviewed by the buyer, the disclosure schedules provide a list of exceptions or additional details regarding the representations and warranties described in the purchase agreement. From the seller’s perspective, the disclosure schedules aid in limiting their exposure since by disclosing known issues, the seller qualifies their representations and warranties. From the buyer’s perspective, the existence of disclosure schedules reduces the risk of misrepresentation or failure to disclose material information by the seller.
D. Dispute Resolution and Damages Mitigation Strategies
Even with well-drafted agreements and thorough diligence, disputes can arise. To proactively manage these risks and limit potential exposure, parties should include tailored dispute resolution provisions in their agreements and take deliberate steps to mitigate damages post-closing.
- Dispute Resolution Mechanisms: Clearly defined procedures for resolving disputes—such as requiring mediation or arbitration—can significantly reduce costs, minimize business disruption, and prevent forum shopping. Mediation clauses encourage early, non-adversarial resolution, while arbitration provides a confidential and often faster alternative to court. Including simple language, such as tiered clauses requiring mediation followed by arbitration, can streamline enforcement and reduce procedural disputes, and also encourage the parties to more fully weigh the pros and cons of pursuing a dispute.
- Mitigating Damages Post-Closing: Courts expect parties to act reasonably in minimizing losses. Buyers and sellers should promptly address known issues, document responsive actions, and explore early settlement options. These steps not only reduce the risk of a prolonged dispute but also preserve legal claims by satisfying the common law doctrine of mitigation, which bars recovery of avoidable damages.
By anticipating disputes and embedding resolution and mitigation strategies in transaction documents, businesses can safeguard the value of the deal and reduce the likelihood of costly post-closing litigation.
E. Post-Closing Covenants and Monitoring
While a deal closing marks a major milestone in a transaction, the work is far from complete in relation to mitigating litigation risks. In fact, the post-closing period is fundamental to ensuring that both parties have held up their respective sides of the bargain. In the months (and at times, years) that follow a successful deal closing, the parties are often bound by certain post-closing covenants to ensure that these commitments have been met. These covenants may include transition services agreements, non-compete or non-solicitation agreements, confidentiality agreements, continued compliance with regulatory requirements, and other performance-based metrics and benchmarks. It is in the best interest of both the buyer and seller to monitor each other’s compliance with the transaction, which may include regular reviews and audits. Ultimately, such post-closing covenants and monitoring help to ensure that both parties follow through on their respective promises and avoid potential missteps that could trigger a litigation dispute.
F. Conclusion: An Ounce of Prevention is Worth a Pound of Cure
From due diligence to the post-closing phase, it is imperative for transactional lawyers to think about the ways in which they can mitigate litigation risks. By proactively identifying and addressing potential legal issues—precisely drafting and addressing such liabilities in the core deal documents and implementing robust post-closing covenants—the parties can ensure a smoother process and actively avoid litigation that would undermine the very purpose of the transaction.
If you have any questions regarding acquiring a business and the associated litigation risks, PilieroMazza attorneys are here to assist you. Please contact Todd Reinecker, Abby Baker, Ashley Krause, Matthew Healy, Nathan Jahnigen, or another member of the Firm’s Litigation & Dispute Resolution or Business & Transactions practice groups.
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If you’re seeking practical insights to gain a competitive edge by understanding the government’s compliance requirements, tune into PilieroMazza’s podcasts: GovCon Live!, Clocking in with PilieroMazza, and Ex Rel. Radio.
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