David A. Ericksen
Attorney at Law
Direct Line: (415) 677-5637
[email protected]
One Embarcadero Center, Suite 2600
San Francisco, CA 94111
Telephone: (415) 398-3344
Facsimile: (415) 956-0439
LATENT DEFECTS:
HIDDEN DANGERS & EXPOSURES IN
DESIGN PROFESSIONAL MERGERS & ACQUISITIONS
David A. Ericksen*
Severson & Werson**
May 2009
Mergers and acquisitions are not new to the design community. Architects and engineers
have been reorganizing and recasting themselves in different forms and under different names
and affiliations for decades, even centuries. For the most part, these changes have been driven
by the entrepreneurial and creative spirit which always indicates that there has to be a better and
more satisfactory way to practice and do business. The individual motivations have varied from
geographic expansion to diversification of services to economies of scale to pure financial
benefit.
The ebb and flow of mergers and acquisitions in the design community has historically
proceeded with a predictability and regularity which largely reflected economic and
demographic cycles. However, some new elements in the equation now indicate that the rate
and intensity of mergers and acquisitions in the design community may accelerate to a fever
pitch. Predominantly, this is a demographic phenomenon and reflects the differing values
of generations. At one end of the spectrum are the “boomers” who have largely built and
developed the current firms. As they reach retirement goals, they are looking to transition their
firms to others and to receive the corresponding financial reward for their years of work devoted
David A. Ericksen is a principal shareholder in and President of the law firm of Severson & Werson in San
Francisco, California, and leads the firm’s Construction and Environmental Practices. For nearly twenty
years, Mr. Ericksen has specialized in the representation of architects, engineers, construction managers,
design-builders, and other construction professionals. Mr. Ericksen's expertise covers all aspects of such
professional practice as lead litigation and trial counsel, as well as being an active resource for risk
management, strategic planning, and transactional matters. He is a trusted and valued resource to design
and construction professionals and their insurance carriers across the United States and beyond. He is a
graduate of Boalt Hall School of Law, University of California, Berkeley, a former law clerk to the
Washington State Supreme Court, and a member of and resource to numerous construction and
environmentally-related professional organizations. Mr. Ericksen is a frequent speaker before
construction professional organizations such as the AIA, SEA, ACEC, CSI and others, as well as providing
in-house training seminars for firms.
**
Severson & Werson has provided legal services throughout California and the country for more than
sixty years. The firm provides counseling and litigation support to all members of the construction process,
including design professionals, construction managers, environmental professionals, owners, contractors,
and insurance carriers.
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to the development of the practice, the clients, and the perceived economic value of the related
goodwill. However, these “boomers” are increasingly finding themselves at odds with the
succeeding generation. By contrast, the later generation, broadly characterized publicly as
“Generation X”, has proven itself far less willing than prior generations to “buy out” its
professional predecessors at traditional pricing in order to perpetuate the existing firm. As
a result, current owners are more often being forced to look externally for their exit strategy
and reward. The result is often a “sale” which results in some form of merger or acquisition.
More recently, the economic turmoil of 2008 has again altered and redirected merger and
acquisition trends in the design community. There have been two prevailing factors in this latest
shift. The first may be starkly characterized as a survival mode. Faced with a frozen or receding
economy, many professionals and firms are being forced to look more aggressively at mergers
and acquisitions as means of limiting, avoiding or sharing capital/overhead costs, achieving
economic efficiencies, or just finding work with viable clients. As a result, it has increasingly
become an attractive “buyer’s” market. The second factor has to do with the need and potential
for maintaining experienced leaders and designers as a part of the business. With 401K plans,
IRAs, and stock indices commonly losing more than 40% of their value in 2008 and with nearly
equal losses in real estate values in some regions, the retirement plans of many experienced
design professionals have undergone forced re-evaluations. As a result, many talented and
valuable professionals are now available to play a meaningful role in merged or acquired firms
for more years than had recently been believed.
The viability of such mergers and acquisitions has also been greatly enhanced by
technological advances in design development and delivery, as well as communication. As
a result, geographic distances which might have precluded some mergers and acquisitions in
the past can arguably now be managed with relative ease and success.
As a result of these combined social and technological factors, the frequency and
significance of mergers and acquisitions in the design community are likely to accelerate and
grow rapidly in the months and years to come. Most often, those discussions and transactions
focus on valuation and the preservation of perceived resources and capital such as clients,
projects, “portfolio”, and staff. In the euphoria of “the deal”, too often little or no attention is
paid to the “what if” scenarios and the potential financial ramifications. Most often, those
“what ifs” relate to potential claims for liability arising out of past or present projects. Given
the elongated development of such claims, the potential exposure may not even be suspected
until years after the project has been completed. Even where potential dangers are considered
as a part of the deal, they are too often forgotten as soon as the deal has been completed and the
parties rush forward to enjoy their financial windfall or to exploit the opportunities acquired in
the transaction. When the fateful “what if” occurs without adequate planning and protection, it
has often been to the severe financial detriment of all parties, and even personal and professional
bankruptcies.
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The focus of this paper is to highlight the nature of these risks and to analyze the strategic
options available to the parties in any merger or acquisition between design firms or practices.
LIABILITIES: PERSONAL OR INSTITUTIONAL?
The old saying would have us believe that “ignorance is bliss”. It is not. It is dangerous.
It is especially dangerous in the arena of professional service providers and professional liability.
An amazing number of design professionals are wholly ignorant of the interplay of personal and
institutional liability as it relates to claims for design errors and omissions.
In the first instance, many design professionals do not take those readily-available and
pragmatic opportunities provided under the statutes of every State to practice in some form of
limited liability entity (e.g., corporation, S corporation, limited liability company, or limited
liability partnership). However, from the perspective of caution, they actually may be the better
equipped practitioners in that they almost all understand that they remain personally exposed in
the event of a significant project failure. In reality, those who practice within one of the limited
liability entities often do so with the naïve expectation that the statutory protections provide them
with a universal blanket of protection for their personal assets and liabilities. They do not.
While the specific provisions and details may vary from State to State, the prevailing law
throughout the United States is that a professional person cannot avoid personal liability for his
or her own malpractice or tortious conduct through incorporation or a similar use of a limited
liability entity. Such professional service providers almost always have their own personal
responsibility and liability for their own actions, regardless of whether or not the act was
performed as an employee or owner of a limited liability entity. (See T&R Foods, Inc. v. Rose
(1996) 47 Cal.App.4th Supp. 1, 9.) As a result, individual architects and engineers face potential
personal liability for their own professional errors and omissions, even where all of their actions
have been within the context of employment or ownership of a design firm with limited liability
status. For example, in one Florida Decision, an aggrieved homeowner sued the individual
engineers who allegedly made a negligently-deficient pre-purchase inspection of a home. The
engineers sought to avoid liability on the basis that the service contract was in the name of their
employer. The Court rejected this defense and stated that the engineers were responsible for
performing professional services to a client of their company and therefore should have known
that the client would be injured if they were negligent in their services. The Court concluded that
the fact the engineers were employees of a corporation did not shield them from personal
liability since professionals are individually liable for any negligence committed while rendering
professional services. (See Moransais v. Heathman (1999) 744 So.2d 973 (Fla.).)
In most instances, individual liability is not a critical issue since the employing entity
remains viable and obligated to provide for the defense and indemnity of the design professional,
as well as providing for adequate insurance and assets through the firm to cover any claim of
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alleged negligence. The firm would typically carry those obligations forward through any
merger or acquisition, but there can be exceptions. Where the firm no longer exists or no longer
carries insurance, the personal exposure remains, but the individual lacks any non-personal
resources to respond to the claim.
ACQUIRE, MERGE, OR DIVIDE?
True mergers and acquisitions should be distinguished from the larger, euphemistic
realm of “ownership transitions”. By most accounts, the preferred model within the world of
ownership transitions is an internal conveyance to the next generation such that the institutional
spirit, pride, and good will are perpetuated. While ownership interests are surely sold and
acquired through an internal conveyance, such transactions are typically distinct from a
true merger and acquisition in that the transfer often takes place over time and often only
incrementally.
A true merger or acquisition is typically more dramatic and immediate in terms of time,
transition, and form. While the forms can vary widely, most such transactions take one of four
forms:
Merger: Two or more entities join ownership to form a new entity. The key here
is whether both entities truly go forward and become a part of the new entity, or whether
a wholly new entity is created with the dissolution of the predecessor entities.

Acquisition. This transaction is distinguished by the continuation of the
acquiring firm with its prior form and structure while the assets, liabilities,
and capital of the acquired firm are absorbed into that entity on some
basis.

Asset purchase. A transaction where the assets are sold or transferred
to another firm while the debts and liabilities of the existing firm are
retained. Most often, such a transaction includes some plan of dissolution
and wrap-up for the firm retaining the liabilities.

Spin-off. This transaction most often represents some partial form of
acquisition or asset purchase, but relates only to a portion of the firm and
its business. It may also involve the creation of an entirely new entity to
go forward with that portion of the business.
In most business sectors, purchasers prefer an asset purchase because it represents the fair
value of the acquired company going forward and does not have to account for the uncertainties
and risks associated with past liabilities. However, design firms are an anomaly in that they
often prefer the merger or acquisition model that allows for a cleaner perpetuation of ongoing
work, as well as preservation of staff and entitlement to the predecessor firms’ portfolio of work.
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THE CONVERSATION, DUE DILIGENCE, AND THE ALLOCATION
Most conversations and negotiations surrounding mergers and acquisitions focus on
the upside of the transaction: the compensation to be received and the potential benefits to the
successor entity. In fact, many such “deals” are essentially done before any consideration is
given to the possible downsides of the transaction and how they are to be resolved. As a result,
these less appealing conversations are too often an afterthought and do not get the early and
appropriate attention they deserve. In fact, the parties are often so emotionally committed to
the transaction that one side or the other simply accepts accountability for future claims without
really considering the ramifications or the actual risks and costs. Where these issues are given
real consideration late in the negotiations, they can be true deal killers. Accordingly, these issues
should be addressed early on as a part of the overall transaction.
The best and cleanest way to start the conversation is as a part of a due diligence
investigation preceding the transaction (and even the negotiation). Any design entity considering
acquisition of or merger with another such entity should investigate the financial condition of the
other entity. An investigation of potential liability concerns can easily be incorporated into that
process. A process of evaluation could and should include the following:

All claims of negligence, breach of contract, or fraud against the firm
within the last five or ten years;

All projects with fee issues such as significant late fees, fee waivers, or
uncharged fees;

All claims with known litigation involving other project participants
within the last five years;

Any circumstances on any project within the last five years which might
reasonably lead to a claim of negligence, breach of contract, or intentional
misconduct against the firm;

All known reports or complaints to State licensing authorities;

The circumstances of departure for any principals or owners within the
last five years;

Any projects terminated by clients in the last five years; and

Any significant changes in professional liability insurance coverage
(e.g., carrier, retroactive date, limits) within the previous five years.
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All of this may be meaningless if it is not authenticated by a sworn and written representation
and warranty by the owners of the company.
Where appropriate, information developed through the due diligence review and
authentication may be verified through contacts with clients, consultants, departed employees,
and insurance brokers, as well as through other means such as internet searches and reviews of
court records.
Any current or potential claims identified through the due diligence process outlined
above should be reported to the predecessor firm’s insurance carrier. While this cannot
guarantee coverage for any undeveloped claim, it minimizes the likelihood that there would
be any gap in coverage asserted by a subsequent carrier based on prior notice.
With all of this in hand, the key conversation then becomes who can and should bear the
risk and exposure of claims arising out of the work. As a default rule, the clearest approach is to
allocate the exposure to the party receiving the benefit from the risk. Unfortunately, the benefits
and risks are not always that clear, and the allocation of responsibility can be heavily influenced
by financial issues and economies. Most often, the comparative arguments include the following
factors:

Predecessor entities are typically seen as the preferred party for purposes
of financial responsibility for past work. They most often enjoy the
financial benefits of the project and have the greatest project knowledge.
Moreover, if dissolution or age is a part of the consideration in the
transaction, such an entity will typically become a lesser target for liability
as time goes by. However, such prior entities often struggle with the
cost of tail insurance coverage, the financial reserves for claims, and
motivation to proactively respond to claims on historic projects.

Successor entities typically have the advantage in that they can often
include such predecessor exposures in their ongoing professional liability
insurance and are financially viable. In addition, to the extent that the
claims relate to clients who remain beyond the transition, it is often
important to demonstrate a continuing responsiveness to their needs.
Finally, providing such protection is often critical to the retention of key
staff and good will. On the downside, the successor firm most often
receives little or no financial benefit from the project, and any claims
which do arise can have significant financial and insurance implications
since the successor will have the comparative appearance of a viable
target.
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Such conversations and allocations are never easy, but they are very important and should take
place as a part of the overall negotiation.
TOOLS TO ENABLE ALLOCATION
To be viable and reliable, responsibility allocations can and must be supported by
adequate resources and commitments. Sometimes the availability of such resources will
actually determine the appropriate allocations, as opposed to merely providing the support
for the allocation. In reality, there are three categories of tools which may be utilized to
reinforce and facilitate the allocation:
Duty of Cooperation. Although it is not a financial issue, each party to be protected
by any of the allocation measures should be obligated to fully cooperate in and support of the
investigation, analysis, response, and defense of any applicable claims. Too often, when the
claims arise, necessary persons and resources have moved on and their commitment to the issues
is not what it could or should be. As a result, protection by the allocations of responsibility
should be expressly conditioned on cooperation in and commitment to the response.
Insurance. Insurance is without doubt the most often discussed and utilized resource
for satisfaction of liability issues arising in the course of a merger or acquisition. The first and
foremost tool is most often a “tail” policy which provides insurance coverage for the predecessor
entity and its owners and employees as to projects performed prior to the transition. Such
policies are often the best and clearest resource to protect against claims for prior work.
However, they can be costly and can have varying durations and coverages. Each claim would
also likely be subject to a deductible payment without a clear resource for that payment. Each
of these issues needs to be evaluated carefully under the circumstances of the transaction and
appropriately monitored.
The alternative to a tail policy is most often incorporation of the predecessor entity and
its exposure into the practice policy covering the successor entity. This can have its own issues
as to retroactive dates of coverage and the identification of covered persons, projects, and entities
covered by the policy. Since such policies are most often written on an annual basis, the
coverage is subject to change and therefore must be monitored carefully. If and when the claim
actually arises, it can have significant insurance and financial implications for the successor
entity.
Indemnity & Financial Guarantees. Where insurance is not available or involves copayments or where there may be other uncovered exposures, it is typically best to identify the
individual(s) responsible for such exposures and to secure those obligations through indemnity
agreements and financial assurances. Sometimes, the security concern can be satisfied through
an escrow or reserve account which can be depleted or reduced over time.
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PAST PROJECTS
All past and completed projects must be readily assigned as the responsibility of one
side or another. Such projects, entities, and persons should then be expressly incorporated into
that party’s insurance coverage, with particular attention to coverage dates. Where one party
is thereby relying on the insurance of another, he or she should expressly require notification
of any change in the terms of the policy, its termination, or claims against the policy. If there
is an applicable duration with obligations for renewal, the relying entity should monitor those
renewals for the duration of the obligation. An acquiring entity should also consider duplication
of coverage on an excess basis in order to provide coverage in the event of any issue impairing
the underlying coverage.
As appropriate and consistent with the discussion above, the insurance and obligations
should be supported by duties of cooperation, indemnity, and financial guarantees in the event
of uncovered losses or claims.
ON-GOING PROJECTS
On-going projects are much more complicated. Since services are on-going, there is
often no clear line delineating the responsibility, and alleged errors and omissions can have
linkage across the transaction.
First and foremost, the parties should make a clear and definitive statement of
responsibility to one another and to other interested parties, including the client at the time of
the transition. Such a statement should include the status of the project, the necessary steps
to be completed, and a declaration as to the ongoing responsibility for the project. Such a
statement will necessarily vary with the project status.
Presumably, all future work will be the responsibility of the successor entity. For
past work on the project, responsibilities should be allocated and insurance and indemnities
coordinated appropriately. Particular attention should be focused on the coordination of
insurance coverage to avoid any gaps. Generally, duplicated insurance is better than having
no coverage.
Where an on-going project will not transition to the successor firm, it is extremely
important to document the termination of services, the status of the project, and that the sole
responsibility for the completion, interpretation, and alteration of the project after termination
shall reside solely with the client or the design professional who assumes responsibility for
the project. Most often, this would occur in a circumstance where less than the complete
predecessor entity is a part of the transfer. The Notice of Termination and Non-Responsibility
is very important for two reasons. First, it can and should be a barrier to subsequent claims for
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future interpretations and alterations. Second, even if the same professional continues with the
project, such a change in entity is often sufficient to start the running of the statute of limitations
as to the predecessor firm and its insurance obligations. (See Beal Bank, SSB v. Arter & Hadden,
LLP (2007) 2007 DAR 15089.) To facilitate such a notification, a letter including the following
should be issued:
As of <date>, responsibility Consultant of Record for the Project shall be
transferred to <name>. As a result, we shall have no responsibility for the
ongoing Project, including, but not limited to completion or interpretation
of the Project documents.
CONCLUSION ON MERGERS & ACQUISITIONS
Mergers and acquisitions continue to present exciting and attractive financial and practice
development options. This is all with good reason. However, the most long standing and
successful transactions will look beyond re-numeration and opportunity and will also assess
and prepare for potential claims which are tied to acts and projects preceding the transaction.
A FINAL NOTE ON EXIT STRATEGIES
A merger or acquisition represents a commitment on many levels. It is professional,
financial, and often personal. As a result, it should not be too easy to simply cancel, back out,
or abandon the deal. Typically the commitment of a merger or acquisition is supported by
financial commitments, transfers of intellectual property rights, infrastructure, exclusive service
commitments, and covenants not to compete. Nevertheless, the professional landscape is littered
with dozens (and sometimes even hundreds) of mergers and acquisitions which have not
succeeded. The reasons are as varied as the firms involved in the transactions. Some of the most
common reasons have been:






Culture Clash;
Failure in Transference of Good Will and Projects;
Financial Failures;
Breach of the Agreement;
Geographic Issues; and
Strategic Revisions
If deferred until the time when a merger or acquisition has not “worked out”, the details
of an exit plan will almost always be complicated, emotional, contentious, and expensive. As a
result, the criteria, framework, and process should be established in advance as a part of the
initial transaction. In doing so, there are four elements which are typically more important than
any others and which should be included in the Agreement.
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Criteria. The first and most significant hurdle is to establish the criteria which would
warrant or justify a termination to the transaction. This will vary dramatically depending
on the transaction, the objectives, and the business. Such elements might include economic
performance, client and project retention, staff retention, and financial impairment. It is also
important to consider whether either party will have a right of unilateral termination and what
financial ramifications, if any, would arise from such an action.
Separation Process & Form. Assuming that there is a basis for termination, the next
three important issues are the form of the separation, the financial responsibilities, and the related
public statements. The form of separation can take several forms including rescission which
would essentially “undo” the transaction as if it had never happened, a sale, spin-off or split
which would result in either the ongoing entity and a new entity or two new entities, or a
dissolution with the subsequent creation of completely new entities to go forward. There will
be financial issues and accountability to be resolved as well which include liability for services
provided by the combined entity and financial obligations of the combined entity including
vendors, leases, insurance, and benefits. These will need to be allocated and resolved. Finally,
there is the question of public statements. Ideally, any public statement would need to be by
agreement in order to minimize damaging information and mixed messages.
Competition & Business Practice. Many, if not all, mergers and acquisitions involve
some element of service agreements and “non-compete” obligations. If the transaction is
terminated, such commitments must also be addressed. Ideally, this will allow each party to
compete for the business it desires without taking undo advantage of information gained solely
from pre-existing knowledge or relationships of the other party.
Dispute Resolution. Hopefully, the foregoing provisions and arrangements will be
sufficient to avoid conflicts and disagreements. However, not all disagreements will be avoided.
Most often, it would only make matters worse if remaining disagreements cannot be resolved
quickly and without a public display. Delay can impair ongoing projects and relationships. A
public dispute such as a lawsuit can be embarrassing, distracting, and expensive. As a result, any
disagreements should be referred to some form of alternative dispute resolution. Ideally, such an
agreement would require mediation within a short time period (e.g., 30 days) through an agreed
mediation service. If the matter cannot be resolved consensually, the matter should then be
referred to an accelerated arbitration within some short time thereafter (e.g., 60 days). Each
process should be expressly required to be confidential.
Used by permission of the author, David A. Ericksen, Esq. Do not reproduce or distribute
without express permission from the author.
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