In This Issue

INDUSTRY NEWS
Escrow Disputes on the Rise According to J.P. Morgan Study
The study showed that claims were made in 40% of all deals where J.P. Morgan served as escrow agent.

FIDUCIARY DUTIES
Watch Out When Approving Distressed Sales
A new court ruling challenges the judgment of directors when they approve a sale in which some of the directors may receive proceeds while the common stockholders are wiped out.

LEGAL DRAFTING TIP
Don't Leave Out the Yankees
A new New York statute could make it significantly more burdensome to grant power of attorney to a shareholder representative.

Escrow Disputes on the Rise According to J.P. Morgan Study

JP Morgan recently completed a study of escrows associated with M&A transactions, looking at 445 deals from across the U.S. that closed between January 2007 and June 2008. The study's results are consistent with both SRS's experience and Cooley Godward Kronish's recent observations that post-closing disputes are on the rise. The study showed that claims were made in 40% of all deals where J.P. Morgan served as escrow agent. In addition, the larger the deal and escrow, the more likely buyers will assert a claim. The study found that claims increased 10% on escrow deposits of greater than $3 million.

In addition to showing claims experience, the J.P. Morgan study includes other summary statistics, such as the purpose of claims and typical escrow periods. If you'd like to get a copy of the study, please contact Kalvin Dickson or Michael Balliet of J.P. Morgan Escrow Services.

ESCROW CLAIMS J.P. Morgan found that in 178 escrow claims:
	> 26% related to reps and warranties > 21% related to purchase price adjustments > 14% related to working capital adjustments > 7% related to adjustments to accounts receivables > 5% related to tax matters > 2% related to environmental matters > 1% related to litigation matters > 24% unspecified

Watch Out When Approving Distressed Sales

Dennis White, an attorney at McDermott Will and Emery, had an interesting post in the New York Times recently regarding the In re Trados Incorporated Shareholder Litigation case. This case questions the degree of deference courts will give directors under the business judgment rule when they approve a sale of a business in which some or all of the directors have a possible conflict of interest and common stockholders are wiped out.

In this case, a VC-backed company was sold for an amount that was small enough that no consideration went to the common stockholders due to the liquidation preferences. At SRS, we see deals like this all the time. However, in this case, the common stockholders sued the company's directors for breach of their fiduciary duty of loyalty to such stockholders, arguing that the company did not need to sell and the directors had conflicts of interest in approving the deal. The Delaware court rejected the defendant's motion for summary judgment and found the plaintiffs had pleaded sufficient facts to rebut the business judgment rule, which usually gives significant protection to directors and officers against second guessing their business decisions. While this does not yet mean that the directors have any liability, it does significantly change their burden of proof in trying to show that they should not be liable for any damages or losses.

This ruling could lead to a heightened level of scrutiny of the actions taken by company directors when approving a sale of a business, especially one where the purchase price is low and does not clear preferences senior to common shareholders, such as debt, management carve-outs and preferred shares.

Directors are in a tough spot because they will have to consider whether entering into the sale is in the best interests of all the shareholders, and those shareholders may have differing interests. For instance, preferred holders may be in favor of doing a deal that gets them their investment back when the company is struggling, while common stockholders may feel they have nothing to lose since they are not getting any merger consideration anyway and would prefer to have the company continue to operate as long as possible to see if it can turn the corner.

The Trados case's rebuttal of the business judgment rule in connection with the decision to sell the business has the potential to heighten the risk involved with being a director who has to vote one way or the other on an M&A transaction, especially for VC or PE directors who may have a conflict of interest as preferred stockholders.

Don't Leave Out the Yankees

We've seen a few deals recently that missed the implications of recent changes to the New York General Obligations Law. This statute could make it significantly more burdensome for an individual in New York to properly grant power of attorney to someone else. This could create a meaningful challenge in merger transactions that require the appointment of a shareholder representative since such representatives are granted a power of attorney to represent the interests of the former shareholders of the target company. Among other things, the new law dictates the size of font that must be used and requires that specific cautionary language be included in the document that grants such power.

These new rules apply to any power of attorney signed by an individual in New York, no matter where they live. Since no assumptions can be made as to where individual stockholders will sign their paperwork, the New York rules appear to apply to almost any transaction that has a target company with multiple stockholders. Therefore, in order to comply with the New York rules, most mergers in which a stockholder representative is being appointed will now have to either use a carefully crafted letter of transmittal that is checked against the requirements of the regulations or use a separate side letter agreement appointing the stockholder representative. Failure to follow the New York rules could result in a stockholder who signed their letter of transmittal in New York later arguing that the representative does not have the power to speak for their interests. Alternatively, an escrow bank could decline to recognize the ability of the stockholder representative to act on behalf of all stockholders if the bank is unsure whether the New York law applies and where stockholders executed the applicable paperwork. This could tie up escrow accounts well into the future. Neither the buyer, the bank, nor the seller wants this uncertainty.

While we understand that state legislatures feel a need to protect their citizens from manipulation, we do not think this law should apply to the granting of a power of attorney by a group of stockholders in an M&A transaction. In the M&A context, it adds a significant burden if followed, and leaves substantial uncertainty if not. We also do not see that it provides much additional protection. The grant of the power in this situation is done by a large group of stockholders rather than an individual. It is significantly less likely that the stockholder representative getting the power of attorney would be able to deceive the whole group. Finally, if every state did this, it would be extremely difficult to get deals done. States would likely have different requirements related to this issue, and trying to navigate them all would be a nightmare.

Our suggestion is that New York revisit this law and more carefully tailor it to the situations where there is the most potential for abuse. We also suggest that it specifically carve out situations in which the law should not apply, such as the appointment of a representative of the stockholder group in mergers. In the meantime, deal professionals will have to be careful to consider the implications this new law will have on their drafting of transactional agreements.

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About SRS

SRS | Shareholder Representative Services saves venture capitalists time and money by expertly managing the post-closing escrow or holdback period following the acquisition of one of their portfolio companies. Since 2007, SRS has represented more than 300 venture capital firms and managed the escrow period in more than 50 venture-backed M&A deals valued at over $7 billion.

For more information visit www.shareholderrep.com

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