ABA Section of Business Law

ABA Section of Business Law
Business Law Today
September/October 1998

Addressing Y2K issues in M&A deals

A lesson in representations, warranties and indemnities

Simon is an associate with Gibson, Dunn & Crutcher, LLP, in Los Angeles.

You're ready to complete a merger agreement and counsel on the other side asks if your client is Year 2000 compliant. How do you respond?

Recent studies show that while more than 90 percent of all Fortune 500 companies will be affected, as of December 1997, two out of three of those same corporations had yet to address, let alone begin to resolve, their Y2K issues.

Corporate counsel must analyze the ramifications of the Y2K problem in the context of any business combinations, such as mergers and acquisitions. They must ensure that the operative agreement contains sufficiently protective representation and warranty, as well as indemnification, language with respect to the Y2K problem and related remediative costs and potential liabilities. Acquiring or merging with another company that uses noncompliant systems or is currently marketing or has in the past marketed noncompliant systems is a sure-fire way to inherit substantial liabilities.

Completing an M&A transaction without adequate due diligence and contractual safeguards regarding Year 2000 issues is a prescription for acquiring potentially enormous liability and compounding any existing problems that the buyer already faces. In addition to the standard due diligence conducted in connection with a proposed business combination, the acquiror should also investigate the scope and severity of the target's Y2K issues. The need for careful and extensive due diligence is heightened when the target is in the banking, insurance or technology-based business, as these industries are even more susceptible to Year 2000 problems.

The Y2K due diligence process requires expert assistance to determine the nature, extent and potential costs of any Year 2000 problems the buyer may inherit. For example, with respect to contracts being assigned or transferred to the buyer that are material to the business or assets being sold, the buyer will have to investigate whether the other parties to the contracts are Y2K-compliant, and if they are not, how and to what extent will the noncompliance affect the economic value of the acquired business or assets. The result of the buyer's due diligence may also lead to a restructuring or renegotiation of the transaction. For example, in an asset purchase deal, in the event that the seller's assets of a particular division or subsidiary are not Y2K-compliant and the remediation costs would be greater than the entity's net revenues justified, the parties might consider spinning off the business division or subsidiary in question to avoid Y2K-related liability.

The issue of Year 2000 compliance should also be addressed expressly and explicitly in the operative agreement. The agreement should include representations, warranties and indemnities regarding Year 2000 issues. In a situation where the seller believes that its company and its assets are Y2K-compliant, the buyer should require the seller to give a representation and warranty to that effect.

The first round of negotiations concerning a representation and warranty on Y2K compliance is bound to be over how the parties define "Year 2000 compliant." The following definition might serve as a useful starting point: "Year 2000 compliant" means, with respect to the seller's information technology, the information technology is designed to be used prior to, during and after the calendar Year 2000 A.D., and the information technology used during each such time period will accurately receive, provide and process date/time data (including, but not limited to, calculating, comparing and sequencing) from, into and between the 20th and 21st centuries, including the years 1999 and 2000, and leap-year calculations and will not malfunction, cease to function, or provide invalid or incorrect results as a result of date/time data, to the extent that other information technology, used in combination with the information technology being acquired, properly exchanges date/time data with it.

The parties must also agree on a definition for "information technology," which should include computer software, computer firmware, computer hardware (whether general or specific purpose), and other similar or related items of automated, computerized, or software system(s) that are used or relied on by the seller in the conduct of its business.

The above definition of "Year 2000 compliant" requires that compliant information-technology products must accurately process date/time information regardless if the date is in this century or the next. Additionally, it recognizes that a compliant product may not accurately process date/time information if it is from a non-Year 2000 compliant source, and carves that scenario out of the definition of "Year 2000 compliant."

However, a distinction should be made between noncompliant software, manufactured and sold by third parties, that the seller has either purchased or licensed for use in its business and comprises part of the assets being sold to the acquiror, and noncompliant software or data that is used by outside parties that could cause the seller's assets to have Year 2000 problems if such software or data interfaces with sellers' computer systems, which is not included in the assets being transferred by the seller. The former should be covered by the seller's representation; the latter is properly excluded pursuant to the exculpatory language referred to above.

The target's representation and warranty should then state that, depending on the nature of the transaction, the target's assets or business or the target itself is Year 2000 compliant. Such language can be modified for use in a company's agreements with suppliers and vendors to ensure that the products being purchased by the company are Y2K compliant, giving the company a viable breach of warranty claim against the vendor if the representation proves false.

Negotiations over representations and warranties often focus on two issues: materiality and knowledge. The buyer will sometimes be satisfied if the seller represents that it is in "material" compliance with certain regulations and laws, or, alternatively, that the seller is in compliance with all laws, rules and regulations, except where the seller's noncompliance would not have a material adverse effect on the seller's business. It is often difficult to determine with 100 percent certainty whether one is in complete, technical compliance with certain regulations, and as long as the noncompliance will not materially and adversely harm the business or assets being transferred, there is little risk to the buyer.

In the Year 2000 context, however, any Millennium Bug in the seller's software has the potential to have a material adverse effect on the seller's business. A problem in one piece of software can very easily have a domino effect on other areas of the company, as one noncompliant system could pollute an entire network. As such, "materially compliant" may prove to be the practical equivalent of "noncompliant" and thus buyers should require a representation that is unqualified by materiality if the representation is to have any value.

Sellers also often try to negotiate for a "knowledge" qualifier to its representations and warranties. For example, the seller may represent that, "to the best of its knowledge, the seller is not the subject of any actual or threatened litigation." A buyer may agree with the seller that a knowledge qualifier is appropriate in this situation, since the seller can only represent as to what it knows, and it would be unreasonable to hold the seller accountable for third-party action of which it is unaware.

While this may make sense in the context of actual or threatened litigation, giving a seller the ability to limit its Year 2000 compliance representation and warranty "to the best of its knowledge" allows the seller to adopt a policy of "willful blindness" and guts the representation of its intended purpose. Certainly the seller cannot profess lack of knowledge regarding the Year 2000 problem, given the widespread media coverage of the issue.

The issue then boils down to whether the seller has assessed its Year 2000 issues, if any, and whether it has undertaken the necessary remediation and testing. If it has, then the question of whether the seller's own assets are Y2K compliant is a simple one: The testing of the seller's assets either shows that they are compliant, or that they are not.

Thus, if the seller has analyzed its Year 2000 issues and has either determined that it has no internal Y2K issues or that it has successfully addressed these issues, then the representation should be clean of any knowledge or materiality qualifiers. If the seller has determined that it is Year 2000 compliant, the buyer should request as a part of its due diligence copies of any and all "Year 2000 compliance reports" that the seller obtained in connection with its Y2K remediation process.

The buyer should require indemnification from the seller for any Year 2000-related costs in the event that the seller's representation should prove to be inaccurate. The parties will need to negotiate the standard indemnity provisions, including dollar baskets and caps, although if the Year 2000 problem for the seller in question has the potential to be fairly severe, any cap that is agreeable to the buyer may prove to be prohibitively high to the seller. The buyer might require that a portion of the purchase price paid to the seller be set aside in an escrow, to be used in the event that the buyer makes any Y2K-related indemnification claims. The survival period of that indemnity should extend at least one year past the turn of the century, to allow time for the buyer to discover any problems in the purchased assets that arise after Jan. 1, 2000.

What if the seller has yet to assess either its Y2K problems or related remediation costs and thus is unable or unwilling to make an unqualified representation? As stated above, to allow the representation to be qualified in any way would deprive the buyer of the benefit of such a representation, as the discovery of any noncompliant software, no matter how seemingly "immaterial" or "unknown," could result in potentially enormous remediation expenses for the buyer.

Instead, the buyer and the seller must then negotiate over who should be responsible for the cost of a third-party assessment of the problem, who will be responsible for paying or indemnifying for the compliance costs and whether the buyer will have the right to "walk away" from the deal or adjust the purchase price if the compliance costs exceed a pre-agreed maximum.

The agreement should include procedures for determining the amount of the Y2K compliance costs. For example, the agreement might provide that the estimate of Year 2000 remediation costs are to be determined by a third-party consulting firm who has expertise in the software field and who is selected by the buyer. If the target disagrees with the third-party estimate, the agreement should provide for dispute resolution, with a time limit for final determination.

The above analysis is equally applicable to the buyer's representations if the deal involves non-cash consideration. If the acquiror is paying the seller with stock of the buying company, the viability of the buyer's business and associated risks become material to the seller. Accordingly, in such a situation, the seller should seek the same type of Year 2000 representation and warranty language and indemnification that it is providing to the buyer.