mitigating litigation risk at the deal table webinar part 1

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Polsinelli PC. In California, Polsinelli LLP Mitigating Litigation Risk at the Deal Table M&A Pre-Closing, Part I

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Page 1: Mitigating litigation risk at the deal table webinar part 1

Polsinelli PC. In California, Polsinelli LLP

Mitigating Litigation Risk at the Deal Table

M&A Pre-Closing, Part I

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Due Diligence; Reps and Warranties; Damages Limitation and Waiver

John L. Babala, Shareholder | Polsinelli

John Babala finds practical and cost-effective means to achieve clients' business goals. His almost 20 years

of practice representing businesses, both private and public as well as individuals, have exposed him to

virtually every challenge or crisis a business can face in nearly every phase of the business or economic

cycle. John handles day-to-day legal matters for clients, as well as their out of the ordinary course

transactions such as mergers and acquisitions, joint ventures and strategic alliances, venture capital and

private equity investments (companies, sponsors and funds), and offerings of debt and equity securities

(including SEC compliance).

Marc B. Leh, Shareholder | Polsinelli

Marc works on a wide variety of business transactions and brings more than 25 years of

corporate and transactional experience to each client engagement. He enjoys working with a

wide variety of clients, from Fortune 100 corporations, to wealthy families and individuals, to

small family-run businesses. Marc has been involved in more than 250 M&A transactions,

ranging in size from $10 million to more than $1 billion, with principal responsibility in most of

these transactions. These transactions have ranged from very complex, multi-party and multi-

jurisdictional matters involving large teams of attorneys working in various countries around

the world, to more straight forward transactions entirely located in the Southern California

area.

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Factors buyer should considerto minimize its risk

� Require thorough due diligence.� Use and stay true to an extensive

diligence request list.� Insist on complete access to all relevant

documents.� If possible, rely on key seller

representations (e.g., inventories, key customers and audited financial information).

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Factors buyer should considerto minimize its risk (cont’d.)

� Due diligence materiality thresholds may be used as proxy for materiality amounts in post‐closing disputes.

� Obtain representations regarding key valuation assumptions.

� Obtain specific representations for high‐risk accounting areas (e.g., inventories are in a saleable/good condition).

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Factors buyer should considerto minimize its risk (cont’d.)

� Scrutinize accounting estimates for key areas (e.g., warranty reserves, allowance for doubtful accounts).

� Maximize indemnity claim caps; no cap on claims related to fraud.

� Minimize basket threshold; maximize escrow.

� Focus on appropriate carve outs to caps for certain representations and warranties.

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Factors seller should consider to minimize its risk

� Clean up seller before the sale process starts.

� Diligence itself – identify problem areas before a buyer does.

� If known departures from GAAP exist, consider “carving out” troubling accounts (e.g., for inventories, insist on past practice).

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Factors seller should consider to minimize its risk (cont’d.)

� Prepare a list of “non-GAAP” exceptions at an early point in the process.

� Limit buyer’s ability to make working capital claims in an indemnification proceeding.

� Avoid nondisclosures that could lead to willful misrepresentation or fraud claims.

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Factors seller should consider to minimize its risk (cont’d.)

� Pay attention to its representations.� Limit damages to dollar‐for‐dollar;

maximize the basket for damages; and insist on cap on indemnification recoveries.

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Disputes over Representations, Warranties, Covenants and Post Closing Adjustments

� The most common post‐deal disputes include:• Breach of representations and warranties. • Claims of material adverse change. • Earnout disputes (both buyer and seller share

the risk). • Post‐closing adjustments for working capital

or net assets.

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Common R&W Disputes

� Financial Statements� Customers and Suppliers� Intellectual Property� Compliance with Laws� Product Liability

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Financial Statement R&W

� The financial statements are often prepared internally by seller and not prepared in accordance with GAAP.

� Buyer and Seller need to be on the same page as to the principles used.

� Attach exceptions to GAAP.� Adjust purchase price if necessary.

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Customers and Suppliers R&W

� Usually a very important part of the business with significant damages if breached.

� Avoid general or vague statements as to relationships.

� Important for buyer to fully diligence key customers and suppliers.

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Intellectual Property R&W

� Often lies at the heart of the business.� Important to get experts involved in

evaluating the strength of the IP as well as the preparation of the applicable R&W.

� As with other R&W’s, knowledge qualifiers can play a big role in limiting liability.

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Compliance with Laws R&W

� Can often be a huge risk for a seller if not appropriately limited and qualified.

� Particular risk if seller has non-US operations.

� Often requires the use of local counsel in significant jurisdictions.

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Product Liability R&W

� Depending on the particular company and industry, can be a source of high dollar post-closing disputes.

� Mitigated by extensive diligence, appropriate risk sharing in the R&W and through insurance.

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Increasing Use of R&W Insurance

� Current insurance offerings are more economically attractive and easier to obtain.

� Growing record of policies issued and claims paid.

� Jury is still out as to ultimate usefulness.

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Disputes Relating to Material Adverse Change

� Seller promises that no material adverse change will occur in the business through the date of closing.

� Protects buyer in the event of a significant decline in the value of the business.

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Examples of material adverse changes

� Loss of a significant customer, contract, or supplier.

� Intellectual property litigation.� Loss of key employee(s).

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Issues with MAC Claims

� Difficult to prove.� Need to show knowledge of the event

would have impacted either the purchase price or decision to purchase the target.

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Factors to be considered in evaluating a MAC claim

� Impact of the event on the company.� Duration of the time period in which the

company was and/or will be impacted.� Were other companies in the industry also

affected and to what extent?� Did either seller or buyer know of the

event prior to signing?

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Earnout Disputes

� Use of earnouts in M&A transactions continues to increase.

� Earnouts are an effective way to bridge the gap between what a buyer is willing to pay and what a seller is willing to accept.

� In an earnout, a portion of the purchase price is contingent on achieving certain future financial milestones.

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Earnouts Concerns – Seller’s View

� Buyer controls the business after closing and may make decisions that seller disagrees with or that differ from what the business has done historically.

� Incentive for buyer to run the business in such a way as to reduce or eliminate the earnout payment.

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Earnouts Concerns – Seller’s View

� Risk Mitigating Factors:• Require buyer to operate the business

consistent with past practices during the earnout period.

• Provide seller with veto rights on major decisions impacting the business.

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Earnouts Concerns – Buyer’s View

� Difficult to make operational changes if seller is still involved in the management of the business.

� Limits the ability to grow the business through further acquisitions or to sell the business or parts thereof.

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Earnouts Concerns – Buyer’s View

� Risk Mitigating Factors:• Provide buyer with rights to manage the

business in its sole discretion if primary purpose is not to reduce the earnout.

• Anticipate and provide for specific actions to be taken during the earnout period (e.g., ROF).

• Put in place controls that review and monitor any decisions seller has the power to make during the earnout period.

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Other sources of dispute related to earnouts

� Earnout benchmarks may be financial, non‐financial or both.

� For a buyer who integrates the acquired company into its other businesses, it often becomes difficult to evaluate the performance of the company on a stand‐alone basis.

� Changes in accounting guidance can impact the calculation of the earnout.

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Earnouts - Risk Mitigation Steps

� Avoid earnouts with multiple components -the simpler, the better.

� Avoid “cliff vesting” of an earnout – use a sliding scale or pro rata basis.

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Earnouts - Risk Mitigation Steps (cont’d.)

� When defining a financial earnout target (e.g., an EBITDA target), affirmatively determine whether to include: • Unusual or extraordinary expenses or income.• Integration and restructuring expenses (e.g.,

inventory write‐offs or bad debt expenses).• Settlements or costs arising from pending

litigation or tax disputes.

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Post‐Closing Adjustments

� Nearly all M&A transactions involve a post-closing purchase price adjustment.

� Such adjustments account for differences in a target’s most recent financial statements and the actual financial condition of target on the closing date.

� Working capital and net assets are the most common items included in post‐closing adjustments.

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Common Disputes Over Post‐Closing Adjustments

� Were the historical accounting methods used by seller, and subsequently the calculation of working capital, in accordance with GAAP?

� Even if GAAP, were the various reserves adequate?

� Were the accounting methods consistently applied to all historical periods under consideration.

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Common Disputes Over Post‐Closing Adjustments (cont’d.)

� Are the definitions for the components of working capital clear and correct?

� Risk Mitigating Factors:• Get a competent accountant involved in the

process early.• Agreed upon non-GAAP exceptions and

specific dollar amounts for reserves.• Be clear on the definition of, and what’s

included in, working capital.

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Common Disputes Over Post‐Closing Adjustments (cont’d.)

• Agree upon level of materiality (e.g., a specified dollar amount).

• Add collars (e.g., no adjustment if actual working capital is within $300,000 (up or down) of target working capital).

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Procedural Safeguards

R. Montgomery Donaldson, Shareholder | Polsinelli

Monty 's practice focuses on business counseling and litigation, with an emphasis on matters involving

complex business transactions, corporate governance, securities, and special proceedings under the

Delaware General Corporation Law and alternative entity laws. Monty's litigation practice also involves a

diverse array of commercial matters, including commercial contract, consumer, and non-compete cases

venued in the District Court for the Federal District of Delaware, the Delaware Court of Chancery and the

Delaware Superior Court. In these and other matters, Monty routinely is called upon to serve as primary

counsel or as Delaware counsel in coordination with reputable firms located throughout the country and

abroad.

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PROCEDURAL SAFEGUARDS

� Litigation challenging deal itself– Price paid– Allocation of consideration

� A potentially important consideration is PROCESS, and in particular PROCEDURAL SAFEGUARDS

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What is “Process”?

� Actions undertaken by management and the board and its advisors in considering, negotiating and ultimately recommending (for or against) a transaction or transactional alternatives

� Includes actions taken to inform stockholders about transaction and solicit their votes in favor of or against

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Why do we care about process?

� From a corporate moralist standpoint, because we care about doing the right thing; getting it “right”

� From a practical standpoint, over 90% M&A transactions worth over $100M end up in litigation, many the subject of multiple suits in multiple jurisdictions

� Potentially very costly to litigate and settle

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Why do we care about process?

� These suits frequently challenge the fairness of the deal terms or the allocation of consideration

� The particular circumstances – which may include the process used or not used –determine the level of scrutiny under which the transaction is scrutinized.

� The level of scrutiny can materially affect the outcome and duration of litigation.

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Why do we care about process?

� Two primary levels of scrutiny, with several intermediate levels and burden shifting adding to the mix of possible types of review: (1) highest level of scrutiny is Entire Fairness and (2) the most deferential is Business Judgment. In third-party transactions involving change of control, Revlon enhanced scrutiny applies if no pre-transaction controller.

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Entire Fairness Review

� Applied where, for example, a controlling stockholder takes the company private or otherwise stands on both sides of the transaction. Deal proponent (such as a controlling stockholder) must demonstrate intrinsic fairness of transaction (to minority stockholders). Two prongs:– Procedural fairness (i.e., fair process)– Substantive fairness (i.e., fair price)

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Entire Fairness: Burden Shift

� Burden of proving absence of entire fairness born by shareholder challenging deal where EITHER:– Deal negotiated by special committee of

empowered, fully informed and truly independent directors OR

– Deal subject to majority of minority vote based on full and adequate disclosures

– Kahn v. Lynch, 638 A.2d 1110 (Del. 1994); Weinberger v. UOP, Inc., 457 A.2d 1262 (Del. Ch. 1979)

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Business Judgment

� Presumption that directors’ recommendation of a transaction was made on informed basis, in good faith and in honest belief that transaction is in the best interest of the company

� To overcome presumption, must show the decision “cannot be attributed to any rational business purpose”

� Business judgment – early dismissal

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Business Judgment Review of Controlling Shareholder Transactions

� Significant development in Kahn v. M&FWorldwide Corp., 88 A.3d 635 (Del. 2014):– Where BOTH (a) approval by empowered,

independent and disinterested committee AND (b) conditioned at outset on unwaivablemajority of minority vote of fully informed stockholders, deal subject to more lenient business judgment review

– Rationale: where both measures employed, controller effectively relinquishes control

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Procedural Safeguards

� Many transactional paradigms (company taken private by controller, sale to third party where no controlling stockholder, etc.), and many procedural safeguards.

� Assume a freeze-out merger, where controller takes company private

� Discuss three safeguards: special committee; maj. of min. vote; disclosures

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Special Committee

� What is a “special committee”? Board committee of independent and disinterested directors convened and duly authorized to critically evaluate, negotiate and recommend (for or against) potential transaction or, where appropriate, to consider and recommend strategic alternatives

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Special Committee Process

� Three areas of focus:– Independence/Disinterestedness– Mandate/Empowerment– Process

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Special Committee

� Independence/disinterestedness– Disinterested: members have no financial

stake or other interest in the transaction that differs from unaffiliated shareholders

– Independent: whether director is beholden to of so under influence of (i.e., controlled by) outside interest that would prevent impartial evaluation of transaction�E.g., active and material financial

relationship with controller or buyer

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Special Committee

� Mandate/Empowerment– Authorized to hire its own legal and financial

advisors– Authorized to negotiate terms– Empowered to say “no” to transaction– Authorized to discuss strategic options with

financial advisor (even if controller will not sell to third party)� other purchasers; different deal structures

altogether (asset divestitures, etc.)

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Special Committee

� Process– Did committee execute on mandate – did it

exercise due care?– Should be functional equivalent of arm’s-

length negotiations with a third party– Genuine negotiations? Did deal terms move?– Actual consideration of alternatives?– Recommendation of deal supported by

deliberative record – is fairness determination supported? Independent advisors?

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Majority of Minority Stockholder Vote

� Two primary issues: vote (1) fully informed and (2) not coerced.

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Majority of Minority Stockholder Vote

� Coercion: board or other party takes action that would cause stockholders to vote in favor of the proposed transaction for reason other than the merits of that transaction– Can be found, e.g., where strong deal

protection measures and voting agreements coupled with no fiduciary-out provision = fait accompli (Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003))

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Fully Informed -- Disclosures

� Disclosure is material only if there is a substantial likelihood that it would be viewed by a reasonable investor as significantly altering the total mix of available information

� Key areas: (1) conflicts of interest, (2) financial projections, and (3) the assumptions and analyses underlying financial advisors’ fairness opinions

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Fully Informed -- Disclosures

� Conflicts of interest – Financial Advisors and Directors and Officers

� Recent DE Cases involve Financial Advisors. Consider disclosing: – (i) the board’s work in determining the lack of

conflicts with potential bidders; – (ii) the historical work that the financial advisor

has done for the buyer in the recent past; – (iii) a description of these projects;

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Fully Informed -- Disclosures

– (iv) the amount of fees paid to the advisor by the buyer;

– (v) the dollar amount of fees paid to the advisor by the target; and

– (vi) the structure of the fee arrangement for the transaction

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Fully Informed -- Disclosures

� Financial information– Delaware generally requires disclosure of

financial forecasts if critical to the analyses performed by the board or financial advisor

– No bright-line rule requiring disclosure of all projections received by either an advisor in preparing its fairness opinion or a board in approving or rejecting a proposed merger; rather, a context-specific analysis is required to determine when enough is enough

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Fully Informed -- Disclosures

� Incomplete disclosure of financial projections that fail to offer clear picture of corporation’s future financial performance may trigger duty to supplement the proxy with materially complete information

� Projections relied upon by target corporation’s financial advisor and board for fairness analysis, and those shared with bidders, are more likely to be material and thus to require disclosure

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Fully Informed -- Disclosures

� Assumptions and Analyses Underlying Financial Advisors’ Fairness Opinions– Generally, shareholders entitled to a “fair

summary” of the analyses underlying the fairness opinion, which may include the basic valuation exercises that the financial advisors undertook, the key assumptions that they used in performing them, and the range of values that were generated.

– No specific checklist

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Fully Informed -- Disclosures

� “Fair summary” does NOT necessarily require disclosure of detailed procedures by which financial advisors came to their fairness opinions

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� For example, sufficient where proxy – detailed the various sources financial advisor

relied on in coming to its conclusions– explained some of the assumptions and

calculations management made to come to its estimates

– noted exactly the comparable transactions and companies the financial advisor used

– and described management’s estimated earnings and EBITDA for relevant time period

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Take-away

� Process counts� An investment in process may (1) make

shareholder litigation less attractive; (2) may shift burden or, in a discrete subset of instances, cause business judgment to apply to an interested transaction, and may; (3) reduce settlement value or facilitate early dismissal

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Regulatory Compliance/Alphabet Soup

Noam B. Fischman, Shareholder | Polsinelli

Noam Fischman serves as a trusted guide in leading clients through commercial litigation matters in

federal and state courts, as well as government investigations and matters involving regulatory agencies. He

has extensive experience advising clients about risk management and risk mitigation efforts in highly

regulated industries, including health care, telecommunications, non-profit organizations, and higher

education. Within these fields, Noam regularly represents clients in complex litigation and dispute resolution

across a wide range of matters, including issues related to the False C laims Act, the Foreign Corrupt

Practices Act, the Telephone Consumer Protection Act, and related state laws.

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Regulatory compliance – The Alphabet Soup

� Due Diligence

� Host of issues to consider that are very fact dependent.

� These ten minutes are meant to be an appetizer for a later presentation on this topic, which will be both broader (more statutory schemes) and deeper (more details) than this one.

� Key questions:

1. What kinds of companies are involved?

2. What are the relevant regulatory schemes?

3. Aside from the deal lawyers, what subject matter experts do you need?

� Laser focus today on one important statutory scheme: FCPA

� Key theme: • Know what you’re buying

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Foreign Corrupt Practices Act (FCPA)

� The FCPA makes it unlawful:– To make payments, or give anything of value, to foreign government

officials, or their agents, to obtain or retain business.– “Anything of value” is broadly defined to mean: gifts, entertainment,

travel, and hospitality; contractual payments; personal favors; donations to an official’s favorite charity; cash, stock/bonds; and much, much more.

– Governmental Official – once again, very broadly defined and not restricted to high-level officials

� Two Key Takeaways:1. A “government official” includes employees of state-owned enterprises

(e.g., utilities, hospitals, etc.). FCPA is implicated if payments are made to relatives of “government officials” as well.

2. Value is also defined extraordinarily broadly.

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FCPA (cont’d)

Why are we talking about bribes?� 2012 DOJ/SEC joint task force released a guide to FCPA

issues. DOJ/SEC was clear:– (a) Successors/purchasers could be held (and are held) liable for the conduct of

predecessors in interest, – (b) but, companies that investigate and remediate and, if appropriate, “self

report” issues can significantly mitigate the risk of successor liability.

� 5 Step Process Per DOJ and SEC: 1. Conduct thorough risk-based FCPA and anti-corruption due diligence on

potential new business acquisitions; 2. Code/culture;3. Training; 4. Post-merger assessment and audit, if necessary; and, 5. (Potential) disclosure (complicated discussion – be sure to include counsel with

government investigations experience).

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Concluding Thoughts

� Upshot:– Due diligence for compliance is a box that must be checked.

– The scope, breadth, and depth of compliance due diligence is fact specific

– For companies doing business abroad, the FCPA is critical to understanding what potential risk is being purchased as a matter and as a broader “tell” for the culture of the target company.

– Culture is an intangible asset (or liability) of target companies.

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Thank you, and we hope that you will join us for our next web cast on December 2, 2015

entitled: Mitigating Litigation Risk at the

Deal Table, Part 2 |Compartmentalizing Liability, ADR, Choice of Law and Venue Selection.

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Polsinelli provides this material for informational purposes only. The material provided in this presentation is general and is not intended to be legal advice. Nothing in this presentation should be relied upon or used without consulting a lawyer to consider your specific circumstances, possible changes to applicable laws, rules and regulations and other legal issues. Receipt of this material does not establish an attorney-client relationship.

Polsinelli is very proud of the results we obtain for our clients, but you should know that past results do not guarantee future results; that every case is different and must be judged on its own merits; and that the choice of a lawyer is an important decision and should not be based solely upon advertisements.

© 2015 Polsinelli PC. In California, Polsinelli LLP.Polsinelli is a registered mark of Polsinelli PC

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