This article presents a practical method by which transactional lawyers can analyze, document, and negotiate complex deals such as securities offerings, financings, mergers, acquisitions, derivative transactions, and real estate deals.
A complex transaction is a lot like a road trip. You need to have the right vehicle. You need to know where you're going, how to get there, and the rules of the road. Very often, parties to a complex transaction look to their lawyer as the driver on these road trips. This can be a rather daunting task, especially for beginning lawyers. It is impossible for counsel to give accurate and pragmatic legal advice without having a complete and thorough understanding of the transaction at hand. With that in mind, I offer below a process by which lawyers can navigate through a complex transaction structure: a "Transaction GPS." The GPS contains 10 points of interest designed to help counsel understand, analyze, and document such a deal. Within the GPS are a number of red flags that may signify legal, regulatory, or structural issues. The process I describe can be used for a variety of deals such as securities offerings, financings, mergers, acquisitions, derivative transactions, and real estate deals. While written with newer lawyers in mind, this method also may be helpful to seasoned professionals. Given that the process is general, and designed for a wide array of situations, it does not address specific substantive legal issues, and you should always be on the lookout for these issues as they arise.
So, let's pull the Family Truckster onto the highway.
Understanding the Transaction
Stop 1: Know Your Client
The very first thing any lawyer should do before dispensing legal advice is know the client. Before even looking at a transaction structure, you should have a thorough understanding of who your client is and what that client hopes to achieve from the deal. Who is your client? What business is the client in? How does the business typically make money? What is the current economic position of the business: is it doing well, is it facing a liquidity crunch, is it anticipating a difficult upcoming economic climate? What are the client's appetite and tolerance for risk? If possible, review your client's most recent financial statement to get a sense of the key business and financial issues with which they are dealing. Finally, it is important to understand the goal of the transaction for your client. Is it making a profit, raising capital, financing a specific venture, entering into a risk mitigation transaction (such as a derivative), or something else?
The goal of this step is twofold: it not only gives you a better understanding of the transaction, it also provides you with the effective negotiation position of the client. This will be important as you negotiate the transaction documents later.
Stop 2: Know the Other Parties
Almost as important as knowing your own client is knowing each of the parties with whom you are negotiating. Try to ascertain the same information as you did for your own client. Obtaining this may be somewhat more difficult, but you still may have access to public filings, news clippings, and information that your own client may have. It is key to understand why each party is entering into the transaction and what they hope to achieve.
Make sure you understand the specific entitiesbeing used by each party. Is it a parent company or a subsidiary? Is it an entity subject to a specific regulatory regime such as a broker/dealer, a bank, an insurance company, or an investment fund?
At this point, be on the lookout for the first red flag: the inappropriate use of a special purpose vehicle. A "special purpose vehicle" (SPV) is an entity that is created for the specific purpose of the transaction at hand and has no other bona fide business purpose. Of course, an SPV can be used legitimately for a variety of transactions such as certain mergers and structured finance deals. However, it also can be used for more nefarious purposes, for example, evasion of tax or securities regulation. Therefore, if the transaction involves the use of an SPV, understand the purpose for which it is being used and make sure that you are comfortable as to its legality.
Draw a Map
Stop 3: Follow the Cash
No road trip would be complete without a map. It's nearly impossible to analyze a complex transaction without a structure chart. So draw one. Draw boxes representing each entity in the transaction, with connecting lines representing the transfer of assets and liabilities. For the more involved transactions, this can be a bit of a challenge, so I find that the easiest first step is to "follow the cash." A cash transfer is the most basic of financial transactions, and filling out the cash transfers first is like starting a puzzle with the corners. Note where the cash starts (often with investors in the case of securities transactions or a bank in the case of financing transactions (or both)) and where it goes, through to where the cash is no longer transferred to other transaction parties. Note where an entity receives cash and passes the entire amount to another party, where an entity passes cash along but retains a profit, and where the cash stops. These facts will begin to paint the whole transaction picture for you.
Stop 4: Complete the Map
Now, fill in the rest of the puzzle. Draw arrows representing the transfer of all noncash assets such as securities, promissory notes, and physical assets. Note where the assets are transferred on the closing date and where future receivables are being exchanged. Also note where a transfer is contingent on the occurrence of another event (for example, a derivative with a "knock-in" or "knock-out" component that gets triggered upon a stock price reaching a certain level). Fill in other liabilities to be assumed by the parties to the extent not already noted.
Don't forget to include the transfer of collateral (noting where it is held and by whom). I often designate collateral with a special symbol (indicating that it is not a clean asset transfer), noting also the nature of the collateral "transfer" as this will vary by jurisdiction. For example, in some jurisdictions such as New York, collateral is often pledged to a secured party, whereby the collateral is controlled by the secured party but still technically owned by the transferor. In other jurisdictions, such as England, the transfer of collateral is often consummated by an outright transfer of ownership; the secured party owns the collateral. Still in other jurisdictions, Japan for instance, collateral is often loaned to a secured party (under what is known as a "loan for consumption"), to be repaid by the secured party upon the satisfaction of the original obligation.
Your transaction may have some additional transfers that I haven't discussed here. Include them in the map; the idea is to have as complete a visual representation of the transaction as possible.
Upon completion of the map, it is time to analyze the transaction to determine the presence of legal issues. I take this phase in two steps. First, I search the transaction for red flags. Then, I look at each party and transaction and assess their legality in the context of the entire deal.
Stop 5: Is Every Party's Role Clear?
One of the quickest signs that a transaction may have a legal issue or that the transaction is not properly structured is the presence of an entity whose role is not quite clear. At this point, look at each of the parties and make sure they have a necessary purpose within the deal. There are three red flags for which to look within this step. First is a party with no arrows pointing to or away from it on your map. If a party is not giving or receiving assets, counsel should question the role this party plays in the transaction, whether such a role is legal (and structurally sound), and, ultimately, how that party's role will be documented. Second is a party with only one connecting arrow. This means the party is only receiving or paying assets, and not the other way around. This may suggest that there is a problem of consideration, or that a party is potentially misusing a special purpose vehicle. It also may suggest that there is a trade being conducted that is not at arm's length. It is also worthwhile to look for parties with an odd number of connecting arrows. That may suggest it is in receipt of an asset without a corresponding obligation, or vice versa; however, it also may suggest that the party is undertaking two obligations in consideration for one receivable (or vice versa), which is not necessarily problematic. Third is a party that is passing through one or several assets it receives to another party (without keeping a profit or commission). This also may suggest the misuse of a special purpose vehicle or some other attempt to evade law or regulation.
If you spot any of these red flags, you should not assume that there is a legal or structural issue. Valid transactions can be structured as I describe above. Rather, when you uncover a red flag, you should give that portion of the transaction extra scrutiny, considering any relevant legal issues and being sure to understand why the deal is structured in this manner.
Stop 6: Is the Structure Unnecessarily Complex?
A big red flag for which to be on the lookout is unnecessary complexity. There is nothing per se wrong with complex transactions; however, where the deal can be structured more simply to achieve the same result, there may be a hidden legal or regulatory issue. To determine if this is the case, first ask yourself what the deal is designed to achieve. Then, consider if the structure can be simplified to produce the same end. If it can, the added complexities--be they additional transaction parties or special purpose vehicles, asset transfers that pass through parties unnecessarily, etc.--should be scrutinized.
Stop 7: Consider Each Transaction Party
After searching the transaction structure for red flags, it is time to analyze each party. The degree to which you can gain comfort on entity-related legal issues will vary depending on the party: your client and its affiliates will likely be able to provide you with corporate minutes, regulatory authorizations, etc. Counterparties may be required to provide this type of information in the due diligence process; however, in some cases, your client may need to rely only on representations, conditions, and/or covenants in the transaction documents and information gleaned from publicly available sources.
Looking at each party should be an exercise in basic corporate law. Start by ensuring that each entity is duly formed, validly exists, and is in good standing under its jurisdiction of organization. If the entity is subject to a specific regulatory regime, also be certain that such entity is in good standing with respect to any relevant authorities (such as the state insurance regulator or the Securities and Exchange Commission). Then, consider whether the entity has the power under its own corporate documents and governmental/regulatory authorizations to enter into the transaction under consideration. Finally, consider whether corporate approval (shareholder, board of directors, officers) and/or governmental or regulatory approval are required. If so, ensure that such approval has been granted, or is contemplated by the transaction documents (typically, as a condition precedent to consummating the transaction).
In some transactions, most notably securities offerings, a party may simply be "Investors" or "The Capital Markets." In this case, it is still necessary to analyze the nature of this group. In the United States, if "Investors" include the public, the offering may need to be registered under the Securities Act of 1933. Registration would trigger ongoing reporting obligations under the Securities Exchange Act of 1934, and counsel should consider the impact of registration and reporting on the issuer. If the offering is not public (or in the case of certain types of public offerings), exemptions may be available. If the securities being offered are shares of an investment fund, counsel should consider registration obligations under the Investment Company Act of 1940 and the related exemptions. In the context of such a fund deal, the fund's adviser also must consider its own registration and reporting obligations under the Investment Advisers Act of 1940. Finally, parties to securities offerings also must consider their obligations vis-^-vis investors. U.S. broker/dealers, for example, have the duty to determine whether or not the securities they sell to clients are suitable for such clients.
Stop 8: Consider Each Exchange
Once you've looked at each party, shift your attention to each exchange drawn on your map. During this step, you should determine whether or not the exchange is legal, and, if it is, whether despite such legality the transaction raises legal issues that should be addressed.
With respect to legality of an exchange, first determine the governing law of each entity involved, as well as that of the exchange itself. Then, conduct the review necessary to ensure the legality of the trade under these laws. At this phase, it may be necessary to employ local counsel. Note that entities may be subject to more than one governing law; for example, a Delaware corporation issuing stock will involve both the corporate law of Delaware as well as the U.S. federal securities law. There may be other jurisdictions involved, as well. For example, if the transaction involves a custodial arrangement or the holding of collateral, it may be necessary to consider the law of the jurisdiction in which the assets or collateral are located.
It is also necessary to consider legal issues, even if you have comfort on the fact that the trade is legal. This analysis will vary from transaction to transaction, but some items I usually consider include tax issues, pension plans law, the potential adverse recharacterization of the exchange by regulators (for example, a purchase and sale being recharacterized as a loan), and validity/perfection of security interests. As you work your way through these issues, note where you may need added protections from your counterparty(ies). These may include, for example, a condition precedent that certain filings will be made to ensure perfection of a security interest, indemnities if a transaction is adversely recharacterized, covenants that a transaction will not involve a pension plan, or the like.
Stop 9: Determine the Required Documents
Now that you know the parties, understand the transaction, and have unearthed the legal issues, it is time to determine the required deal documents. The most logical place to begin is by listing required contracts. The task here is simple; look at each exchange on your map and determine how it is to be documented. Most exchanges (purchase and sales, loans, posting of collateral) will be consummated via contract. In some cases, one contract may encompass more than two parties; in others, multiple exchanges will be conducted via a single contract. In any event, each line on your map connecting two parties should have some document evidencing it.
Of course, contracts will not be the only documents involved in a complex transaction. The precise documents involved will vary for each transaction, but some of the most common other documents include securities prospectuses, collateral financing statements (and other documents used to establish and perfect a security interest), officer's and other certificates, regulatory filings, and proxy statements. The analyses you conducted during stops seven and eight will be particularly helpful in determining the documentary requirements.
Stop 10: Term Sheet and Transaction Checklist
As for any road trip, you need to be organized. Jumping into documentation drafting before the parties have agreed on the basic terms of the transaction and the responsibilities of each party could result in wasted time.
First, start with a term sheet. Hopefully, your client had prepared something in writing that summarized the transaction before you even began your analysis. Use that as a basis for a more formal term sheet. Include the basic terms of the transaction: each entity involved, each exchange being conducted, and each document that will be required. The parties should agree on the substance of the term sheet before proceeding with the time and costs of the more formal agreements.
Then, prepare a transaction checklist. The checklist is a list of each task required, the responsible party or parties, and the target deadline. While it is typically the lawyer's role to list the relevant documents, the businesspeople on all sides of the transaction also should include other closing tasks required. Again, the parties should agree on who is responsible for what and the deadlines for each task before the substantive work begins.
Negotiation and Documentation
By now, you should have a comprehensive understanding of the transaction. With your map, term sheet, and transaction checklist in hand, you can begin negotiating and drafting your deal documents. Remember to refer to your map and your transaction analysis frequently as these tools will greatly assist you in these tasks. For example, during stops one and two, you gained critical knowledge about the parties involved in the deal; this information will be valuable to assessing your client and your counterparty's positions as you negotiate. During stops seven and eight, you may have uncovered representations or conditions that should be included in the deal documents. Be sure to consider these provisions as you negotiate the transaction. Bon voyage!