What happens if your company gets acquired, and you find out later that the buying company has put “toxic” financing in place that could dramatically dilute the shares that you receive in the deal?

According to the recent case of Vega v. Jones, Day, Reavis & Pogue (California Court of Appeal, Second Appellate District), you can sue the buying company’s lawyer for fraud.
The facts are unique and – for M&A lawyers – not comforting.

The case involved two companies that merged at the moment just before the dot-com bubble burst in early 2000. The shareholders of the acquired company, Monsterbook.com, received shares of Transmedia, a publicly traded company that had, according to its SEC filings, a capital deficit that raised “substantial doubt about its ability to continue as a going concern.”

Between the date of the merger agreement and the closing of the merger, Transmedia entered into a $10 million financing arrangement that included highly dilutive “toxic” stock conversion features. Jones Day prepared a two-page disclosure schedule that described the financing. That disclosure was not delivered to the seller, and a different disclosure schedule that ultimately was delivered to seller did not describe the “toxic” conversion features.

Two weeks before the merger closed, Transmedia filed its revised corporate charter documents in Delaware, describing the “toxic” stock. The merger closed, and months later, legal actions ensued.

One case was an action by the majority shareholder of the seller against seller’s counsel, for malpractice. Other cases followed suit. Vega, a minority shareholder of Monsterbook.com, sued Transmedia and Jones Day.

Vega alleged that Jones Day deliberately concealed the “toxic” provisions and had stated to seller’s attorneys that the financing terms were “nothing unusual.”

Generally speaking, transaction attorneys expect to represent their clients’ interests, and expect to have no duty to the parties on the other side of a transaction to disclose any particular fact made known to them by their clients, in the absence of specific direction from a client to make such disclosure.

Moreover, in the M&A context, it is typical for representations about the accuracy and completeness of disclosure in the merger documents to be the specific contractual obligation of the parties, regardless of whether the disclosure schedules have been drafted or reviewed by counsel.

In this case, the court stated that Jones Day “specifically undertook to disclose the [financing] transaction, and having done so is not at liberty to conceal a material term.” The court then stated: “Even where no duty to disclose would otherwise exist ‘where one does speak he must speak the whole truth to the end that he does not conceal any facts which materially qualify those stated.’”

For purposes of this case, the court put buyer’s counsel, and not the buyer, at the center of the concealment. Nothing in the case discusses the circumstances of how a complete and detailed disclosure schedule prepared by Jones Day was not delivered to the seller, and a "sanitized" version came to be delivered instead. It does not seem to be an unreasonable speculation that the reason the more complete document was not delivered was that the buyer, for whom Jones Day was counsel, directed that it not be.
The court did not state that a cause of action was available to the plaintiff because the attorney was willing to countenance, or perhaps even facilitate, fraud by its client, the buyer. Rather, the court permitted an action to proceed based on the claim that a fraud was perpetrated by the law firm itself.

The content of M&A disclosure schedules depends on the specific wording of the specific contractual representations that the disclosure schedules modify or explain.
Preparation of such schedules is unique to each particular transaction and there is nothing in the reported case that helps the reader understand whether the disclosure schedule actually delivered was consistent with what the contract required by its terms.
The case involved motions on whether the fraud action against Jones Day could be brought at all, so whether the plaintiff's case ultimately is successful or even does to trial won't be known for a long time, if ever.

Bruce Dravis is a partner at Downey Brand LLP, operating primarily in the firm’s Sacramento and Roseville offices, specializing in corporate, securities and business law. His column appears in The Daily Journal on the third Monday of each month.