• The New Chapter in M&A Transactions: Assessing Year 2000 Compliance
  • May 7, 2003
  • Law Firm: Vedder, Price, Kaufman & Kammholz, P.C. - Office
  • A new chapter is being written in the M&A manuals. The acquisition of a company or its assets brings with it the distinct possibility of assuming Year 2000 compliance liabilities (i.e., computer systems incapable of accurately recognizing and processing date-related information subsequent to December 31, 1999). As a result, a seller's Year 2000 compliance (or lack thereof) has come to the forefront of the buyer's due diligence process. In addition, representations and warranties as well as termination and indemnification provisions in M&A documents must be carefully drafted by the buyer's counsel to address, quantify and minimize the buyer's potential exposure regarding Year 2000 compliance issues.

    The buyer needs to develop a systematic means of assessing the potential Year 2000 liability in the due diligence process. Standard M&A due diligence document requests and management interviews should be updated to include an investigation of Year 2000 compliance issues. The materials provided to the buyer by the seller should be reviewed and interviews conducted by qualified, knowledgeable due diligence team personnel. In addition, the buyer must be prepared to modify the due diligence investigation and transaction structure to incorporate the delay associated with the lengthier process of assessing a seller's Year 2000 compliance and determining and/or implementing a remedy.

    After the seller's computer hardware and software have been inventoried, the seller's software license agreements, related maintenance contracts and actions to ensure Year 2000 compliance should be carefully examined. All software license and maintenance agreements should be reviewed to assess a number of issues, including among others, user or developer responsibility for Year 2000 compliance, representations and warranties as to Year 2000 functionality and "source code" access.

    Is the seller representing to be Year 2000 compliant? If yes, a complete review of all seller's Year 2000 compliance actions should be undertaken. The goal of this phase of the due diligence investigation is to ascertain who did what and whether it was effective. Such an investigation will likely involve the review of, among other things: (i) the development and implementation of any Year 2000 compliance strategic plans, which should include a review of the software code; (ii) the capabilities of the seller's personnel responsible for Year 2000 compliance; (iii) the documentation regarding the use and retention of outside consultants; and (iv) the documentation regarding the ongoing relationship between the seller and each of its software developers and outsourcers. Such review should focus on a number of issues: Did the seller turn over to and rely on the developer to fix the problem? If yes, were the representations and warranties in the license agreements updated to reflect the "fix?" Did the seller purchase upgrades or different software to address the problem? Did the seller obtain the "source code" to review and make the necessary software modifications and undertake such modifications? In any event, what was the fix and was it tested? If testing occurred, under what conditions and what were the test results? These are the types of questions that a buyer will need to ask and have answered to ascertain liability for the seller's Year 2000 compliance as well as any potential liabilities arising out of the fix.

    Given the potential cost of Year 2000 compliance, a company may decide to sell its assets with Year 2000 problems rather than correct such problems. If the seller is non-Year 2000 compliant, further investigation is necessary. The investigation should ascertain the time, responsible party and cost involved to make the seller Year 2000 compliant. More likely than not, the seller's audited financials and/or the corporate records will reflect the seller's assessment of its Year 2000 compliance exposure. The seller's self-assessment may serve as a starting point for the buyer's own Year 2000 compliance efforts for the assets or company to be acquired. The cost of bringing the seller's operations into compliance will undoubtedly impact the purchase price.

    However, a due diligence investigation focused exclusively on the computer hardware and software and on actions taken by the seller to become Year 2000 compliant leaves the buyer open to potential liability in several other areas. For example, the buyer should review the seller's tax returns to ensure proper tax treatment of the costs incurred to become Year 2000 compliant. Failure to properly document the Year 2000 costs, improperly characterizing, improperly expensing or capitalizing such expenses, or improperly amortizing the costs associated with Year 2000 problems may create a future tax liability for the buyer, as successor to the seller.

    Another possible area of liability is the seller's labor and employment practices. The seller's retention, payment and termination practices with respect to outside consultants, independent contractors or employees retained to address Year 2000 compliance issues may give rise to liability. For example, terminated individuals may claim severance and other benefits arising out of employee status even though the seller viewed them as independent contractors. The buyer may be liable to such individuals or, at a minimum, be the first deep pocket such litigants look to for recovery.

    The contractual provisions in the M&A transaction documents also need to address Year 2000 compliance issues. The seller should represent and warrant, among other things, that its computer systems: (i) are able to handle information and functions before, during and after January 1, 2000; (ii) will function accurately and without interruption before, during and after January 1, 2000, without any change or failure due to the start of the new century; (iii) will accurately respond to two-digit input without regard to the new century; and (iv) will accurately store and provide output of date information before, during and after January 1, 2000. In addition, the seller's tax, employee benefits, securities and financial reporting, copyright and trademark rights and litigation representations and warranties, among others, should also be drafted with an eye toward liabilities arising out of Year 2000 compliance.

    Further contractual protections to be considered include, among others, the survival of the relevant representations and warranties, termination clauses and indemnification. The survival period for those representations and warranties addressing Year 2000 compliance is likely to become a heavily negotiated matter. However, failure to have such representations and warranties survive beyond the Year 2000 will limit the buyer's remedies. Post-signing due diligence and "material adverse change" termination provisions that provide the buyer with the ability to terminate the agreement without liability if the cost of seller's Year 2000 compliance exceeds an agreed-upon amount or otherwise "materially adversely" impacts the seller should be fully explored by the buyer. Likewise, post-closing indemnification holdbacks of a portion of the purchase price should be considered as a means of protecting the buyer. A portion of the purchase price can be placed in an escrow following the closing for an agreed-upon period of time to pay for costs associated with Year 2000 compliance. A holdback may be a workable solution in those instances where the seller asserts Year 2000 compliance and such compliance is not confirmed by the buyer's due diligence investigation. However, regardless of the protective measures used in structuring the transaction and in drafting the transaction documents, no prudent buyer should rely solely on the transaction structure and document protections. In every event, Year 2000 compliance due diligence conducted by knowledgeable representatives capable of assessing the magnitude of the buyer's exposure must be undertaken to support and identify the best transaction structure and necessary protections.

    In conclusion, Year 2000 compliance should be fully incorporated into both the due diligence process and the protections provided to the buyer throughout the transaction documents. Liability associated with Year 2000 compliance is likely to arise out of many seemingly unrelated areas of the seller's business. The due diligence investigation and transaction documents must be structured to encompass these areas as well as the computer systems themselves.