M&A Negotiation & Scheduled Litigation: Deal Terms for Managing Third-Party Lawsuits

"A bad agreement is better than a good lawsuit,” as the maxim goes, bears more than a kernel of wisdom. SRS Acquiom has found that this is particularly apt when a company embroiled in litigation is acquired. But litigation cannot always be settled on command. When settlement is not feasible, the buyer and seller must carefully negotiate the indemnification parameters, who controls the litigation, and how the “scheduled litigation” against a third party is to be managed (so called because the litigation normally appears as a specifically indemnifiable matter in a schedule to the definitive agreement). The common thread is that both buyers and sellers should perform due diligence to determine the scheduled litigation’s potential costs and liabilities, and then work closely together after closing to minimize the potential for disputes.

Active litigation, when present, is often the single most significant indemnity issue when a company is acquired.

Active litigation, when present, is often the single most significant indemnity issue when a company is acquired. This paper explores how buyers and sellers can best avoid typical post-closing disputes with strategies and deal terms that may help your next M&A deal ward off challenges with potential scheduled litigation.

Settle Litigation Before Closing – Even on Less than Ideal Terms

Litigators know that lawsuits have inflection points where a settlement is more likely to occur, often after a court order or key deposition that allows the parties to better gauge the likelihood of success as well as the potential exposure in the event of a loss. Forcing a settlement discussion at another point can signal weakness or desperation.

Even so, sellers should strongly consider settling the litigation before closing even on terms they would not otherwise have considered accepting without a looming deal closure. In some cases, the acquisition itself causes the litigation to become more valuable to the plaintiff. A savvy plaintiff’s counsel may grasp that the litigation is indemnified and likely backed by escrow funds locked in-place until the matter is resolved. In these circumstances, plaintiff can effectively control (or at least substantially influence) when and how escrow funds are ultimately disbursed, which disproportionately increases their leverage in settlement negotiations.

The plaintiff’s counsel may also intuit the target company has greater resources following the acquisition and thus more able to pay a substantial judgment. Fledgling startups with uncertain futures make poor litigation targets, resulting in a lower settlement value. Strategic buyers and private equity funds are perceived as deep pockets, resulting in a higher settlement value.

Sometimes, the settlement value increases post-closing as the buyer invests in and grows the acquired company’s business or incorporates it into the buyer’s own platform. This is particularly the case with intellectual property claims like patent or trademark infringement, where the infringing party’s liability may be tied to its revenue. In these cases especially, sellers should strongly consider settling before the acquisition becomes public.

But settling the litigation is wise even where there is not a substantial risk the litigation’s settlement value will increase after closing.

But settling the litigation is wise even where there is not a substantial risk the litigation’s settlement value will increase after closing. Managing scheduled litigation requires aligning multiple stakeholders whose interests do not always sync naturally. Scheduled litigation is best avoided altogether.

Who Controls the Litigation After the Acquisition Closes?

If the matter cannot be settled, a threshold issue to resolve is who will control the conduct of the litigation after the acquisition closes: the buyer, or the sellers through the shareholder representative. Neither option is the intrinsic “best,” but there are advantages and disadvantages to strategically consider.

For sellers who are fully indemnifying losses arising from the litigation, the benefits of deciding whether, when, and how to settle, and what counsel to use, are obvious. A professional shareholder representative, with experienced commercial litigators on staff to manage third-party litigation on the sellers’ behalf, is essential. An experienced shareholder representative team will solve problems for clients, going beyond the support of routine needs such as identifying and retaining appropriate outside counsel litigating the matter, helping determine overall litigation and settlement strategy, and handling invoicing.

Control, however, entails paying legal fees. By its nature, representations and warranty insurance (RWI) does not cover scheduled litigation. An expense fund should be established to support the litigation all the way through trial if necessary. It can be difficult to raise funds from sellers after closing if the expense fund runs low. The expert team at SRS Acquiom has managed hundreds of these kinds of situations. Our team suggests that if sellers assume control, they also take the preventative measure to negotiate the right to tap escrow funds for reimbursement of legal expenses, particularly if the expense fund set aside at closing is not “trial-sized.”

Some sellers, however, are not inclined to direct the litigation—even with a professional seller representative. Assuming control may not be an option for sellers where the buyer is especially sensitive to reputational concerns, the prospect of setting a bad precedent, the risk of losing critical intellectual property, or simply unwilling to cede command of a lawsuit naming a company it now owns.

Here is sample language providing the seller representative with the right to assume control and be reimbursed for legal expenses:

Consider a Dedicated Escrow Account

If the scheduled litigation is significant, setting up a dedicated escrow to secure indemnified losses may help the parties define the scope of indemnity and set expectations while protecting other escrowed funds.

SRS Acquiom has tracked a distinct trend in recent years toward multiple escrows securing different indemnified obligations.

SRS Acquiom has tracked a distinct trend in recent years toward multiple escrows securing different indemnified obligations. For example, according to the SRS Acquiom 2021 Deal Terms Study,¹ deals with a dedicated purchase price adjustment escrow have steadily increased from 52% in 2017 to 68% in 2020, and the escrow value as percentage of overall deal value has likewise increased. SRS Acquiom has also perceived that a higher percentage of deals have a dedicated tax escrow, especially to secure sales tax obligations that have occurred in recent years.²

Setting up a dedicated escrow to secure the scheduled litigation losses is more likely to allow for the timely release of other escrowed funds securing general indemnity obligations or the purchase price adjustment. Most general indemnity escrows are scheduled for release within 12 to 18 months after closing. The most recent data from SRS Acquiom shows that no indemnification claim (excluding purchase price adjustment) was made in 62% of all deals.³

With a segregated escrow in place, general indemnity escrow funds may be released to the sellers even as the scheduled litigation goes on (and on, and on). Buyers remain protected from the risk of the litigation while sellers secure some of their consideration, creating an early and easy win for both parties if they plan for it.

¹ The 2021 M&A Deal Terms Study analyzes more than 1,400 private-target acquisitions ($285.8 billion) that closed from 2016 through 2020.
² Source: 2020 SRS Acquiom Deal Terms Study
³2020 M&A Claims Insights Report analyzing 574 post-closing activity in private-target with escrows that released between Q3 2018–Q3 2020.