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Commercial & Business Litigation

Using Employees Retained after an Acquisition in Litigation

By Mark R. Jacobs – August 16, 2012

When private equity firms acquire a new business, many of those firms hire former employees of the acquired business to stay in key positions after the transaction closes. Retained employees have valuable institutional knowledge crucial to achieving the business’s goals as the business moves forward as a private-equity-backed venture. Those retained employees may also have substantial knowledge that is material to any post-closing disputes that may arise between the buyer and the seller of the business. For instance, the buyer may hire the business’s controller and later discover that the financial information provided to the lawyer by the seller during due diligence was inaccurate, thereby breaching the seller’s representations and warranties regarding the accuracy of its financial statements. Or the buyer may retain the business’s head of sales and subsequently determine that the seller breached its representations and warranties concerning its projected orders from its top customers.

In situations such as these, the retained employees can provide crucial insight into the seller’s operations that is relevant to litigation over the seller’s conduct in connection with the acquisition, such as identifying the seller’s key players and describing the seller’s business methods that gave rise to the buyer’s claims. In fact, the employees retained by the buyer may have participated in the activity that is the subject of the buyer’s allegations. Although the retained employees may be valuable resources in litigation, their prior relationship with the adverse party and their personal involvement in any potential misconduct raise important issues to be considered in preparing a buyer’s litigation strategy.

Understand the Employee’s Relationship to the Buyer
Many decisions about the use of retained employees in litigation will be heavily influenced by the employees’ business and legal relationship with the buyer. A buyer is often an entity created by the private equity firm solely for the purpose of acquiring the seller’s business. The private equity firm controls the purchasing entity, and principals from that firm decide which of the seller’s employees to retain. Employees that have the type of knowledge that is most helpful in litigation typically hold management or upper-level positions in the business and are perceived by the private equity firm as critical for success beyond the eventual resolution of the dispute. Those retained employees often have employment contracts that define their employment arrangement with the buyer, including their duties, authority, and protections against termination. In addition, many private equity firms offer retained employees the opportunity to obtain ownership interests in the business after the acquisition as a retention incentive and to align the employees’ interests with those of the private equity firm. Some private equity firms even require that retained employees participate in the ownership of the business.

If retained employees will play an integral role in litigation against their former employer, it is important to determine their relationship to the buyer early in the matter. All contracts governing their relationship with the buyer should be reviewed, including any operating agreement, shareholder agreement, or other corporate governing documents that may control the employees’ rights as equity owners in the business. As explained below, the employees’ participation in the ownership of the buyer’s business and continued employment by the buyer may become a focus of the seller’s response to the buyer’s claims. The employees’ contractual rights and protections, as well as their importance to the buyer’s business operations, may restrict the options for dealing with the seller’s tactics.

Determine Any Duties That the Employee Has to the Seller
Retained employees are often hesitant to discuss information they learned while working for the seller. Not only are they concerned that their involvement with the seller’s conduct will affect their relationship with the buyer, but they may also worry that they have continuing duties to the seller to maintain information as confidential. These concerns are usually easily addressed, but understanding any possible lingering duties to the seller will help the employee become comfortable with discussing material information.

The employment of critical employees by a buyer is usually negotiated as part of the acquisition transaction with the seller. In fact, the employment contracts for those employees are often exhibits to the purchase agreement. Therefore, the seller agrees that the retained employee will be employed by the buyer and cannot object that the mere employment violates any duties to the seller. If the continued employment of retained employees is not part of the negotiations with the seller, any potential noncompetition restrictions should be reviewed. Even if the seller agrees that the buyer may hire former employees of the seller, the employees may still be concerned about contractual restrictions on disclosure of confidential information that may otherwise survive the end of their employment with the seller.

Retained employees may have signed confidentiality agreements with the seller or be bound by confidentiality restrictions in policies instituted by the seller. The benefit of those agreements and policies typically inure to the business that the buyer purchases. As part of the acquisition transaction, those benefits are often expressly assigned to the buyer. Further, the buyer normally acquires all of the information, intellectual property, and goodwill that the seller used in running the acquired business. Consequently, the retained employees’ knowledge concerning the business should belong to the buyer, not the seller. In some instances, an employee may have signed a confidentiality agreement with an entity other than the seller, such as the parent company of the seller, increasing the complication of evaluating the employee’s duties in the context of litigation.

Although the scope of any confidentiality restrictions rarely, if ever, prevents a retained employee from disclosing information about the seller after an acquisition, concerns about an employee’s duties to the seller might further be alleviated through provisions in the purchase agreement between the buyer and seller. For instance, when a buyer intends to hire a seller’s employees, the purchase agreement might include an express waiver or acknowledgment that any of the employees’ obligations to the seller (or its parents and affiliates), including any confidentiality obligations, are terminated as of the date of the acquisition.

Anticipate the Seller’s Attacks on the Retained Employee
In litigation, a seller will try to undermine the value that its former employees provide to the buyer’s case. A seller will probably focus on the buyer’s continued employment of the retained employee to demonstrate that the buyer’s accusations are baseless or, at least, overstated. If a buyer asserts that the seller’s actions were improper, the seller will question why the buyer continues to employ the people who were actively involved in that alleged misconduct. This argument is particularly potent if a buyer claims that it was defrauded by the seller, yet continues to employ those who committed the fraud.

The seller may take an even more aggressive approach and file third-party claims against a retained employee based on the employee’s involvement in the conduct underlying the buyer’s allegations. For instance, the seller may assert claims for breach of fiduciary duty or breach of the employee’s duty of loyalty stemming from the prior employment with the seller. The seller may allege that the employee’s independent actions caused the breaches asserted by the buyer or that the employee failed to make the seller aware of information that should have been disclosed to the buyer. If the buyer asserts a claim for fraud, the seller may seek to join the employee as a party personally liable for any fraud committed by that employee. When a seller puts a retained employee at risk, that employee will often turn to the buyer for guidance and protection. The buyer should anticipate how to deal with the seller’s attacks on the employee.

Minimizing the importance of the retained employee may mitigate the seller’s ability to raise the employee’s connection to the buyer as an issue in litigation. One way to distance the employee from the buyer is to fire the employee. The buyer may be hesitant to fire the employee for business reasons, and termination may be difficult or impossible as a result of the employee’s contracts with the buyer. By terminating the employee, the buyer will also lose access to the employee’s knowledge, compounding the difficulty of pursuing claims against the seller. However, firing the retained employee can be an effective option that eliminates many other challenges that potentially affect the litigation.

The buyer may also reduce the employee’s profile in any dispute by relying on evidence and testimony from other sources and witnesses. The buyer could retain an expert to provide testimony concerning the seller’s business practices and their effects on the transaction. After an acquisition, private equity firms often bring into a business new members of management who have no connection with the seller. Those employees are usually experienced in the relevant industry and can provide sophisticated testimony concerning pertinent issues.

If the seller asserts claims against the retained employee, the employee will often have to hire separate counsel. The employee may ask the buyer to indemnify the employee for the cost of defense and for any liability related to the seller’s claims. The buyer may already have indemnification obligations to the employee under any employment contract negotiated in connection with the acquisition. If those provisions are drafted broadly enough, the buyer may be responsible to the employee for the seller’s claims. Even if there are no existing obligations, the buyer may feel compelled to indemnify the retained employee for business and strategic reasons. The buyer should be made aware of the possibility of these extra costs as early as possible, and any indemnification agreement negotiated after litigation begins should be carefully crafted to specifically define the buyer’s obligations.

Retained employees might be the most valuable source of information in litigation against the seller of a business, but their involvement presents many challenges that are not found in other circumstances. Meeting those challenges requires a thorough understanding of the underlying acquisition transaction beyond the discrete legal issues that trigger the dispute between the buyer and seller. Early communication with the buyer about its expectation and review of all relevant transaction documents are critical to foreseeing and effectively addressing those unique problems.

Keywords: litigation, commercial, business, acquisitions, employees, private equity firms

Mark R. Jacobs is a partner in the Cleveland, Ohio, office of Taft Stettinius & Hollister LLP. He is a cochair of the Private Equity Litigation Subcommittee of the Commercial & Business Litigation Committee.

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