April 29, 2014

Buying and Selling a Business in Uncertain Times

Presented By:

Grant M. Gaines ggaines@patelgaines.com

Rahul B. Patel rpatel@patelgaines.com

Special Thanks to:

Scott McCarty smccarty@patelgaines.com

This paper is only designed to provide a general overview of the material covered herein and is not intended as legal advice. This paper is not intended, nor shall it create an attorney/client relationship between Patel | Gaines and its reader. If you have specific legal questions, you may contact Mr. Gaines directly.

Drafting Ancillary Docuuments

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The purpose of ths paper is to discuss some important documents necessary in the sale of a

business that are ancillary to the primary purchase agreement. Determining which ancillary

documents are required depends on the nature of the transaction. We will discuss some

common ancillary documents—important provisions of each of these documents and how they

relate to each other—such as promissory notes, bills of sale, real estate documents, pledge and

security agreements, escrow agreements, and consulting and independent contractor

agreements. In addition, this paper will briefly discuss how these documents, and the provisions

contained within them, can assist buyers and sellers of business in uncertain economic times.

I. PROMISSORY NOTE

A promissory note is an unconditional written promise signed by the maker to pay a sum of

money to a bearer or a designated person. A note that qualifies as a negotiable instrument can

be a cash equivalent in a commercial transaction.1 The terms, interest rate and payment

structure can be very important in making the purchase or sale of business viable.

A. Time and Demand Notes

Promissory notes are typically categorized as either time notes or demand notes. A time

note contains a promise to pay a fixed amount of money with interest on a specified day to a

lender. Rather than pay the entire balance of the note at one time, a borrower may wish to make

several payments on specific days under an installment note. In contrast, a demand note

permits a lender to call for payment at any time for any reason. If a lender insists on a demand

note, a borrower may seek to negotiate conditions upon which the lender may call for payment.

For example, the note may provide that that lender exercise good faith when calling for payment

or that the debtor is entitled to refinancing should the loan be called. When drafting a demand

note, be advised that excessive provisions concerning default and remedies may create

ambiguity as to whether note is in fact a demand note or a time note.2 Although demand notes

may allow a buyer to negotiate a lower interest rate or better terms, the uncertainty of demand

1 See TEX. BUS. & COM. CODE §  3.101 et seq. (providing the requirements of negotiable instruments). 2 See, e.g., Bank One, Texas, N.A. v. Taylor, 970 F.2d 16, 31–32 (5th Cir. [Tex] 1992), cert. denied, 508 U.S.906 (1993).

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notes, without the proper precautions in place, can make the long-term plan and success of the

business difficult. Lastly, if the parties are not concerned with the negotiability of the note, the

parties may combine the note and the security agreement into a single instrument.

B. Notice and Prepayment

A lending institution that lends more than $50,000 may be required to include in the note the

statutory notice language of Texas Business and Commerce Code Section 26.02. The note may

explicitly state the interest rate or refer to identifiable and accessible source outside of the

agreement, for example, the published prime rate. A note may be silent as to prepayment,

prohibit prepayment before the maturity date, allow for prepayment with a simple “on or before”

clause, or, in a more complex transaction, provide for prepayment under certain conditions,

such requiring notice of prepayment or limitations on amounts of prepayment. As with demand

notes, the inability to prepay the note without penalty may allow buyers to negotiate lower

interest rates and better terms; however, a buyer should always consider whether the

prepayment penalties outweighs the reduced interest rate.

C. Loans, Interest Rates and Usury Laws

One of the key items in determining if the purchase of a business is going to be successful is

the purchase price of the business. For example, unless you have access to unlimited funds you

will most likely need to borrow the money. This can be accomplished through a third-party

lender or the seller.

If you choose to use a third-party lender there are numerous funding options including:

friends and family, Small Business Administrative loans (“SBA loan”) , conventional loans,

and/or business and personal lines of credit. The ability to borrow money from a friend or family

member at a low interest rate may be the quickest and easiest route. Most times the terms are

better, no credit checks are required, and the process is much quicker; however, for those of us

who don’t have rich family and friends, an SBA loan might be the next best option. There are

some factors to consider with SBA loans, which make them particularly unique such as

prepayment penalties, however, in most instances an SBA loan is very favorable option. If a

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conventional loan is required, remember to stay away from variable interest rates or low

introductory rates that skyrocket after the first six months to a year. A little higher fixed rate will

allow you to calculate the business’s financial needs more accurately, allowing for more

informed contract negotiations and business planning. Buyers also must be mindful of default

interest rate provisions. Default interest rates are those rates charged to the borrower if the

borrower defaults under the promissory note or any other document associated with the loan

and sale. Buyers must carefully read these sections as the smallest default may trigger this

provision allowing the lender to greatly increase the interest rate for the remainder of the term.

Due to the current state of the financing market, many buyers and sellers are foregoing

traditional loans and looking to seller financing to meet their monetary needs. In general, seller

financing is when the seller of the business in essence “finances” the business by allowing the

buyer to make installment payments over a period of time directly to the seller for the purchase

price of the business. Seller financing, if available, allows buyers and sellers to consummate a

sale in a shorter time period when a third-party lender is unwilling to lend. Should the parties

agree to some type of seller financing, it is critical to properly paper the sale to insure that both

parties are protected should one party default on their obligations. Promissory notes are also an

important part of seller financing as well as security agreements and guarantees, which will be

discussed in this paper.

Whether it’s an SBA loan, conventional loan or seller financed all parties, especially sellers,

should be conscious not to violate usury laws when setting interest rates. Usury is “interest that

exceeds the applicable maximum amount allowed by law.”3 A usurious transaction involves “(1)

a loan of money, (2) an absolute obligation that the principal be repaid, and (3) the exaction of a

greater compensation than allowed by law for the use of the money by the borrower.”4 The rate

at which interest becomes usurious turns on whether the parties contracted for a specific rate of

interest. If the agreement is silent as to the rate of interest charged, the maximum interest rate is

3 TEX. FIN. CODE ANN. § 301.001 (West 2013). 4 Holley v. Watts, 629 S.W.2d 694, 696 (Tex. 1982).

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six percent per annum.5 In a commercial loan transaction in which the parties agree to specific

interest rate or range, the maximum rate of interest is 18 percent per annum.6 Acceleration may

become usurious if the lender does not adjust the amount of interest in accordance with the

shortened maturity date.7 Texas law contains a few safe-harbor provisions, with which

compliance offers a complete defense against usury.8 In addition, sellers may include language

in the promissory note that states the interest charged therein is not intended to exceed the

maximum amount allowed by law. Although this language may assist in making an instrument

not usurious on its face, it will not assist a party who actually charges and collects usurious

interest.

D. Acceleration Clauses

Acceleration clauses provide the lender the right to demand payment of the outstanding

balance immediately under certain conditions. Most promissory notes contain acceleration

provisions that make the entire balance due “at will” or upon the happening of some event. If the

balance may be accelerated at will, the creditor must, in good faith, believe that “the prospect of

payment or performance is impaired.”9 Because acceleration is a harsh remedy, Texas courts

strictly construe acceleration clauses.10 A lender must provide the borrower with clear notice of

intent to accelerate, and if the borrower continues in default, the lender must provide notice of

acceleration.11 Because two separate notice requirements exist, waiver clauses must clearly

5 TEX. FIN. CODE ANN. § 302.002 (West 2013). 6 TEX. FIN. CODE ANN. § 301.001 (West 2013); C.I.O.S. Foundation v. Berkston Insurance, 2000 U.S. Dist. LEXIS 2337 *19, n.10 (N.D. Miss. 2000) (citing Texas law). 7 See Chavez v. Aetna Finance Co., 553 S.W.2d 174, 176 (Tex. Civ. App.—San Antonio 1977), writ ref’d n.r.e. per curiam561 S.W.2d 799 (Tex. 1978) (equating shortening the term of the loan with raising the interest rate). 8 TEX. FIN. CODE ANN. §  303.401 (West 2013); TEX. FIN. CODE ANN. §  341.406 (West 2013); TEX. FIN. CODE ANN. §  305.105 (West 2013); TEX. FIN. CODE ANN. §  349.101 (West 2013). 9 TEX. BUS. & COM. CODE ANN. § 1.309 (West 2013). 10 Ramo, Inc. v. English, 500 S.W.2d 461, 466 (Tex. 1973); Burns v. Stanton, 286 S.W.3d 657, 661 (Tex. App.—Texarkana 2009, pet. denied). 11 Ogden v. Gibraltar Sav. Ass’n, 640 S.W.2d 232, 233–234 (Tex. 1982); Burns v. Stanton, 286 S.W.3d 657, 661–662 (Tex. App.—Texarkana 2009, pet. denied).

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and unequivocally refer to either the notice of intent to accelerate, the notice of acceleration, or

both.12

E. Installment Loans

A debtor may wish to make installment payment on its promissory note—that is, periodic

payments of the unpaid principal and interest. In structuring the payment of the note, be advised

that a promissory note cannot require both equal payments of principal and interest with a

balloon payment.13 Most installment loans contain provisions related to charges for late

payments. Late charges are considered interest under Texas usury law, so creditors must

ensure late penalties are not usurious.14 Common variations of installment loan provisions

include the following: monthly installments for regular amortization, monthly installments with a

balloon payment; monthly principal installments plus interest; monthly installments on a

changing schedule; and monthly installment with interest-only payments. In order for an

installment note to remain negotiable, the note must contain either the total number of

installments or the date on which on all principal is to be repaid.15 Although, installment loans

are a great vehicle for purchasing businesses, parties must be cognizant of installment loans

that require large balloon payments at the end.

F. Guaranty Agreement

A guaranty agreement “creates a secondary obligation whereby the guarantor promises

to be responsible for the debt of another and may be called upon to perform if the primary

obligor fails to perform.”16 “Guarantor,” “surety,” and “accommodation party” are all generally

synonymous under the Texas Business and Commerce Code.17 But a surety not party to a

12 Shumway v. Horizon Credit Corp., 801 S.W.2d 890, 894–895 (Tex. 1991); see also Phillips v. Allums, 882 S.W.2d 71, 73–74 (Tex. App.—Houston [14th Dist.] 1994, no writ. 13 EMC Mortg. Corp. v. Davis, 167 S.W.3d 406, 414 (Tex. App.—Austin 2005, pet. filed). 14 See Dixon v. Brooks, 604 S.W.2d 330, 333–334 (Civ. App.—Houston [14th Dist.] 1980, ref. n.r.e.). 15 TEX. BUS. & COM. CODE ANN. §  3.104(a) (West 2013. 16 Wasserberg v. Flooring Servs. of Tex., LLC, 376 S.W.3d 202, 205 (Tex. App. Houston [14th Dist.] 2012) 17 TEX. BUS. & COM. CODE ANN. § 3.419 (West 2013).

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negotiable instrument is not an “accommodation party.”18 No common law duty of good faith

exists between a guarantor and principal,19 but contractual good faith duties may exist.

Guarantors may offer four types of guaranties:

1. Guaranty of payment (absolute guaranty)–makes the guarantor primarily liable and waives any requirement that the holder first pursue action against the debtor.20

2. Guaranty of collection (conditional guaranty)–makes the guarantor liable after the holder exercises reasonable diligence to first collect from the debtor.

3. Specific guaranty–a guarantee limited to a specific period of time or a specific

transaction.21

4. Continuing guaranty–contemplates a series of transactions or a course of dealing and remains in effect until revoked.22

Whether the purchase is seller-financed or third-party financed it is imperative that, if the

purchasing party is an entity, the seller require a personal guaranty from one or more of the

principals or individual involved with the entity.

II. BILL OF SALE

A bill of sale is an instrument for conveying title to personal property.23 Within the context of

buying or selling a business, a bill of sale functions to transfer assets (e.g., fixtures, equipment,

trade name, etc.). No provision of the Texas Business and Commerce Code governs bills of

sale, so common law principles of contract control.

18 Id. 19 Associated Indem. Corp. v. Cat Contracting, 964 S.W.2d 276, 280–282 (Tex. 1998). 20 Hopkins v. First Nat. Bank at Brownsville, 551 S.W.2d 343, 345 (Tex. 1977); Ford v. Darwin, 767 S.W.2d 851, 854 (Tex. App.—Dallas 1989, writ denied). 21 Beal Bank SSB v. Biggers, 227 S.W.3d 187, 192 (Tex. App.—Houston [1st Dist.] 2007, no pet.) (involving a specific guaranty that forbade increasing the principal on the note). 22 Beal Bank SSB v. Biggers, 227 S.W.3d 187, 192 (Tex. App.—Houston [1st Dist.] 2007, no pet.); Sonne v. F.D.I.C., 881 S.W2d 789, 793 (Tex. App.—Houston [14th Dist.] 1994, writ denied). 23 Fowler v. Stoneum, 11 Tex. 478, 1854 WL 4306 (1854); Smith v. Smith, 200 S.W. 540 (Tex. Civ. App. El Paso 1917); Billings v. Warren, 21 Tex. Civ. App. 77, 50 S.W. 625 (1899).

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i. Requirements under common law

According to the common law, a bill of sale is executed when it is signed and

delivered24—neither a witness25 nor an acknowledgment26 is generally required. The bill of sale

should sufficiently describe the goods it intends to convey or make reference to a sufficient

description in another instrument comprising the transaction.27 If the sale involves an immediate

transfer of title, rather than an executory promise, a bill of sale may be used to consummate the

transaction.28 While an oral bill of sale is valid in Texas, a writing memorializing the agreement is

advisable. The Texas Business and Commerce Code does not require bills of sale to be

recorded, but bills of sale may be recorded if they are “acknowledged, sworn to with a proper

jurat, or proved according to law.”29 In a dispute regarding the meaning of terms in a bill of sale,

the intention of the parties is dispositive.30 Intent is ascertained by the language of the

instrument and extrinsic evidence meant to explain ambiguous terms.31 Therefore, both parties

should list in as much detail as possible all the personal property items that will be transferred

as part of the sale.

ii. Bill of sale for business property and name

For the sale of a business, the bill of sale should reflect the sale of the personal property

and an assignment of the seller’s interest to the purchaser. Generally, such a transaction also

involves a promissory note, so the bill of sale should include reference to the note as

consideration for conveying the property. If the seller is financing the transaction, the bill of sale

may include a vendor’s lien to secure the promissory note. In addition, the bill of sale should

24 Smith v. Smith, 200 S.W. 540 (Tex. Civ. App. El Paso 1917). 25 Lang v. Daugherty, 74 Tex. 226, 12 S.W. 29 (1889). 26 Campbell v. Eastern Seed & Grain Co., 109 S.W.2d 997 (Tex. Civ. App. San Antonio 1937); Guedry v. Jordan, 268 S.W. 191 (Tex. Civ. App. Beaumont 1924). 27 Billings v. Warren, 21 Tex. Civ. App. 77, 50 S.W. 625 (1899); Goldberg v. Bussey, 47 S.W. 49 (Tex. Civ. App. 1898); Trabue v. Ash, 200 S.W. 415 (Tex. Civ. App. Beaumont 1917). 28 Barton v. Lary, 283 S.W. 920 (Tex. Civ. App. El Paso 1926). 29TEX. PROP. CODE ANN. § 12.00 (West 2013). 30 Bell v. Twaddell, 45 S.W.2d 697 (Tex. Civ. App. Amarillo 1932); Smith v. Smith, 200 S.W. 540 (Tex. Civ. App. El Paso 1917). 31 Nichols v. Lorenz, 237 S.W. 629 (Tex. Civ. App. San Antonio 1922).

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include any representations or warranties as to the condition of the property be sold, such as the

term “as is.” This may also be accomplished by incorporating by reference the warranties set

forth in the asset purchase agreement; however, a prudent practitioner should set forth the

language of the warranties directly in the bill of sale even if it is considered redundant.

iii. Goodwill

In an agreement to sell or purchase a business, “goodwill” refers to the “advantages that

accrue to a business on account of its name, location, reputation, and success.”32 Goodwill can

spring from the professional services of the business, generally, or from a particular person

associated with the business. Goodwill is a property right that is separate from the business

itself.33 Thus, specific granting language must be included in the purchase agreement in order to

convey goodwill.34 The transfer of goodwill may be implied if, as part of the transaction, the

seller agrees not to compete with the purchaser after the transaction commences.35 Whether the

purchase agreement transfers the seller’s goodwill is a fact issue for the jury.36 In addition, as

part of the goodwill transfer, a buyer should request that any logos, trade names, trademarks,

and/or websites also be transferred so that the buyer can continue to use these items to procure

the greatest benefit from the seller’s goodwill.

iv. Covenants not to compete

The seller may agree to not compete in the future with the purchaser. Such an

agreement may be within or ancillary to the purchase agreement.37 Covenants not to compete

are important in business transactions and should be requested by all buyers when purchasing

a business. But, the limitations in the covenant must be reasonable; that is, they may not

32 Swinnea v. ERI Consulting Engineers, Inc., 236 S.W.3d 825, 837 (Tex. App.—Tyler 2007) aff'd in part, rev'd in part, 318 S.W.3d 867 (Tex. 2010). 33 Sanderfur v. Beard, 249 S.W. 274 (Tex. Civ. App. San Antonio 1923). 34 Edelstein v. Edelstein, 6 S.W.2d 400 (Tex. Civ. App. San Antonio 1928), writ dismissed w.o.j., (Dec. 5, 1928). 35 Riddlesperger v. Malakoff Gin Co., 229 S.W. 636 (Tex. Civ. App. Texarkana 1921), writ refused, (Jan. 18, 1922). 36 Airflow Houston, Inc. v. Theriot, 849 S.W.2d 928 (Tex. App. Houston 1st Dist. 1993); Taormina v. Culicchia, 355 S.W.2d 569 (Tex. Civ. App. El Paso 1962), writ refused n.r.e., (July 25, 1962). 37 Farmer v. Holley, 237 S.W.3d 758, 760 (Tex. App.—Waco 2007, pet. denied).

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impose a greater than necessary restraint on the seller.38 If the court finds the limitation to be

unreasonable, the court may reform the covenant.39 Only after a court's reformation can a party

seeks damages.40 In addition, the covenant not to compete should be supported by

consideration; that is, a portion of the sales price should be specifically dedicated to purchase of

the covenant not to compete. Since covenants not to compete are highly regulated, both the

seller and buyer should have the covenant reviewed by attorney to discuss its implications and

enforceability.

III. REAL ESTATE DOCUMENTS

A. Purchase Agreement

A valid conveyance of property requires the parties enter an enforceable agreement,41

which may comprise more than document.42 A real estate contract must comply with the statute

of frauds43 and the statute of conveyances.44 Generally, a writing is required to convey real

property.45 All the essential elements of a contract must be apparent on the face of the

agreement; otherwise, it is unenforceable.46 The agreement must sufficiently describe the

property conveyed.47

i. Types of Sales Contracts

A marketing contract describes a present conveyance of title in exchange for full

payment of the price or a promissory note with a mortgage securing its payment. An installment

38 TEX. BUS. & COM. CODE ANN. §  15.50(a) (West 2013); Drennen v. Exxon Mobil Corp., 367 S.W.3d 288, 295 (Tex. App.—Houston [14th Dist.] 2012, pet. filed). 39 TEX. BUS. & COM. CODE ANN. §  15.51(c) (West 2013). 40 Id. 41 Simpson v. Green, 231 S.W. 375 (Tex. Com. m'n App. 1921). 42 Joiner v. Elrod, 716 S.W.2d 606 (Tex. App.—Corpus Christi 1986, no writ); Longinotti v. McShane, 184 S.W. 598 (Tex. Civ. App.—Texarkana 1916, ref.). 43 TEX. BUS. & COM. CODE ANN. § 26.01(b)(4) (West 2013) 44 TEX. PROP. CODE ANN. § 5.021 (West 2013). 45 Seber v. Union Pacific R. Co., 350 S.W.3d 640 (Tex. App.—Houston [14th Dist.] Aug 16, 2011), appeal after remand on other grounds, 2012 WL 2015793 (Tex. App.—Houston [14th Dist.] Jun 05, 2012). 46 Lewis v. Adams, 979 S.W.2d 831 (Tex. App.—Houston [14th Dist.] 1998, no pet.); Buhler v. McIntire, 365 S.W.2d 237 (Tex. Civ. App.—Austin 1963, ref. n.r.e.). 47 Broaddus v. Grout, 258 S.W.2d 308 (Tex. 1953); Reiland v. Patrick Thomas Properties, Inc., 213 S.W.3d 431 (Tex. App.—Houston [1st Dist.] 2006, pet. denied).

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contract is one which the seller retains title to the property until the purchaser pays off the

balance of the purchase over time in installments. An installment contract will frequently contain

an express vendor’s lien, allowing the buyer to foreclose on the property for non-payment of the

promissory note. Even if the seller does not retain an express vendor’s lien, in a seller-financed

transaction, a vendor’s lien is implied as a matter of law.

However, when a project is seller financed the seller should require the sale be

conveyed by deed of trust. A deed of trust allows the property to be foreclosed on by a trustee if

the buyer defaults, instead of having to go through the judicial process. When preparing a deed

of trust the seller should consult an attorney to make sure the document contains all the

necessary language regarding the appointment of substitute trustees, notice requirements, etc.

ii. Statute of Frauds

A contract for the sale of real property must be in writing and signed by the parties

against whom enforcement could be sought.48 No suit can be maintained unless these

requirements are met.49 In addition the contract itself, both the offer and acceptance must also

be in writing and signed in order to prove the mutual assent of the parties.50 Neither

consideration nor the terms of payment must be expressed in writing.51 Additionally, the

purchase price is not required to be in writing if the contract contains a method by which to

calculate the purchase price.52 The property must be described with reasonable certainty.53 The

level of specificity required is not as high as the property description requirement in a deed.54

The contract may compromise more than a single document55 (e.g., a notice of non-judicial

48 TEX. BUS. & COM. CODE ANN. § 26.01 (West 2013). 49 Transcontinental Realty v. Lupton Trust, 286 S.W.3d 635, 639 (Tex. App.—Dallas 2009, no pet.); Chambers v. Pruitt, 241 S.W.3d 679, 687–688 (Tex. App.—Dallas 2007, no pet.); Swinehart v. Stubbeman, McRae, Etc., Inc., 48 S.W.3d 865, 875 (Tex. App.—Houston [14th Dist.] 2001, pet. denied). 50 Mann v. Risinger, 423 S.W.2d 626, 633 (Civ. App.—Beaumont 1968, ref. n.r.e.). 51 Botello v. Misener-Collins Company, 469 S.W.2d 793, 794–795 (Tex. 1971). 52 Meridien Hotels v. LHO Fin. Partnership I, 255 S.W.3d 807, 810 (Tex. App.—Dallas 2008, no pet). 53 Broaddus v. Grout, 152 Tex. 398, 258 S.W.2d 308, 309 (1952); Morrow v. Shotwell, 477 S.W.2d 538, 539 (Tex. 1972); Fears v. Texas Bank, 247 S.W.3d 729, 735–736 (Tex. App.—Texarkana 2008, pet. denied). 54 Krueger v. W.K. Ewing Co., 139 S.W.2d 836, 839 (Civ. App.—El Paso 1940, no writ). 55 Overton v. Bengel, 139 S.W.3d 754, 758 (Tex. App.—Texarkana 2004, no pet.)

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foreclosure with the accompanying deed of trust). Under this composite approach, the second

document must sufficiently describe and reference the first document in order to satisfy the

statute of frauds.56 The description is insufficient if identification requires parol evidence.57 An

important exception to the statute of frauds exists—an oral contract for the sale of real property

is valid if the purchaser 1.) pays consideration, 2.) takes possession, and 3.) makes permanent

and valuable improvements with seller’s consent.58

iii. Conditions

A condition precedent is an act required after the execution of the contract that must

happen before a there is right a “right to immediate performance and before there is a breach of

a contractual duty.”59 A variety of common provisions exist that condition the sale on the buyer’s

performance. For example, consider the following: sale conditioned on the buyer purchasing

another property; sale conditioned on the buyer selling other real property; sale conditioned on

the buyer obtaining financing at a particular interest rate; and sale subject to negotiation of

leases. The benefiting party may waive the condition.60

When negotiating the terms of a deal, conditions can be very useful. For a buyer it is very

important to have a financing condition with expressed limitations in the contract. Thus if the

buyer is unable to secure financing pursuant to the limitations set forth in the contract, he can

cancel the contract with out penalty. In seller-financed transactions, the seller should have a

condition that requires the buyer to meet certain financial qualifications, if not the seller can also

cancel without penalty.

56 Id. 57 Wilson v. Fisher, 144 Tex. 53, 188 S.W.2d 150, 152–153 (1945); Maddox v. Cosper, 25 S.W.3d 767, 772 (Tex. App.—Waco 2000, no pet.). 58 Sharp v. Stacy, 535 S.W.2d 345, 347–351 (Tex. 1976); Ward v. Ladner, 322 S.W.3d 692, 700 (Tex. App.—Tyler 2010, pet. filed). 59 Thedford Crossing, L.P. v. Tyler Rose Nursery, Inc., 306 S.W.3d 860, 869 (Tex. App.—Tyler 2010). 60 Bans Properties v. Housing Auth. of Odessa, 327 S.W.3d 310, 313 (Tex. App.—Eastland 2010, no pet. h.); Wright v. King, 17 S.W.2d 98, 101 (Civ. App.—El Paso 1929, ref.).

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iv. Risk of Loss

For contracts executed after 1989, the Vendor and Purchaser Risk Act61 (Act) governs

the risk of loss between a seller and purchaser. Under the Act, the risk of loss turns on whether

the purchaser has taken possession: If, before legal title transfers and before the purchaser

takes possession, the property is destroyed without the fault of the purchaser, the seller is

barred from enforcing the contract and the purchaser is entitled to the return of all money paid

under the contract.62 In contrast, if, before legal title transfers but after the purchaser takes

possession, the property is destroyed without the fault of the purchaser, the purchaser is not

relieved of her obligations under the contract and may not recover any of the money already

paid.63

v. Fixtures

Fixtures are personal property annexed to realty.64 Texas courts employ a three-part test

when determining whether personal property is a fixture:

(1) Has there been a real or constructive annexation of the property in question to the realty?

(2) Was there a fitness or adaption of the article to the uses or purposes of the realty

with which it is connected? (2) Was it the intention of the party making the annexation that the chattel should

become a permanent accession to the freehold?65 Unless the agreement specifies otherwise, fixtures pass with the conveyance of the

property.66 Therefore, it is important that parties understand the nature of the property being

sold so as not unintentionally convey an asset that should have remained with the seller, and

61 TEX. PROP. CODE ANN. § 5.007 (West 2013). 62 Id. 63 Id. 64 Fenlon v. Jaffee, 553 S.W.2d 422, 428 (Tex. Civ. App. Tyler 1977). 65 Id. at 428. 66 Milam v. Coelman, 418 S.W.2d 329, 331–332 (Civ. App.—Corpus Christi 1967, ref. n.r.e.).

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vice-versa. If a party is unsure he should include a specific provision excluding that asset from

the sale.

B. Types of Deeds

A deed is a written document that evidences the intent of an owner of an interest in real property

to convey all or part of that interest to another person.67 To be effective as a deed, the document

need not have all the formal parts, nor must it contain certain technical words. Instead, if a

grantor and grantee can be ascertained, there are operative words of grant indicating grantor’s

intention to convey title, a sufficiently described real property interest, and the instrument is

signed and acknowledged by the grantor, it is a deed.68 There are three main deed types: (1)

General Warranty Deed; (2) Special Warranty Deed; and (3) Quitclaim Deed.

i. General Warranty Deed

The term “general warranty deed” applies to deeds with an express guaranty or

assurance of title, as well as implied covenants of warranty.69 An express warranty binds the

grantor to defend against any title defects, whether created by the grantor or by a prior

titleholder.70 It is the grantor’s promise “to warrant and forever defend” the premises “against

every person claiming it.” As such, a buyer should insist on conveyance of the real property by

way of general warranty deed.

ii. Special Warranty Deed

If a buyer cannot obtain a general warranty than at the very least he should demand a

special warranty deed. A special warranty deed is created by adding to the general warranty

clause the phrase “by, through, or under the grantor but not otherwise” so that the covenant

addresses only claims of persons deriving their interest in the property through the grantor.71

Under a special warranty, the grantee is protected against encumbrances or any cloud on the

title created by the grantor, but not claims by anyone prior in the grantor’s chain of title or by a 67 See Johnson v. Cherry, 726 S.W.2d 4, 5–6 (Tex. 1987) 68 Green v. Canon, 33 S.W.3d 855, 858 (Tex. App.—Houston [14th Dist.] 2000, pet. denied) 69 Davis v. Andrews, 361 S.W.2d 419, 421 (Tex. Civ. App.—Dallas 1962, writ ref’d n.r.e.) 70 Munawar v. Cadle Co., 2 S.W.3d 12, 16 (Tex. App.—Corpus Christi 1999, pet. denied) 71 Boswell v. Farm & Home Sav. Ass’n, 894 S.W.2d 761, 765 n.1 (Tex. App.—Fort Worth 1994, writ denied)

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stranger to the title. The additional language makes no change in the statutorily implied warranty

of title. But the language does restrict the implied warranty against encumbrances to an

assessment, tax, or other lien arising with the grantor’s involvement.72

iii. Quitclaim Deed

A quitclaim deed, unlike a general or special warranty deed, does not convey title to the

property itself; rather, it merely conveys the title or interest the grantor may have in the property.

Therefore a buyer should not be willing to purchase a business in which the owner is only willing

to provide a quitclaim deed.

C. Title Commitment

When purchasing a business that includes real property it is imperative that the buyer get a

title commitment. In general, title commitments are used to determine what encumbrances are

on the property, as well as if the seller has good title to the property. If any “red flags” are raised

during the title process then a buyer will have the opportunity to request the seller cure the

defects in title or cancel the contract with out penalty.

A title commitment defines the “terms and conditions on which a title insurance company is

willing to issue its policy,” including any relevant exceptions, requirements, and terms.73 Title

commitments are effective only for a limited period of time (ALTEX-90 days and ALTA 6-

months). Because sales often close after title commitments expire, a sales contract should

require the seller obtain an updated title commitment before closing. When reviewing a title

commitment, take note of the signature of the underwriter and agent, the effective date, the

property description, any existing liens, and the existence of a due-on-sale clause.

D. Title Insurance

Generally, title insurance describes an insurance policy in which a title company indemnifies

an owner of real property, or another interested in the real property, against loss or damage

72 TEX. PROP. CODE §  5.024 73 TEX. INS. CODE ANN. § 2701.001 (West 2013).

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resulting from . . . [a] defect in the title to the real property.”74 The insurer agrees to defend the

insured against adverse claims included in the insurance policy.75 Under the Texas Deceptive

Trade Practices Act (DTPA), a title insurer can be held liable for making a false representation

about the absence of an encumbrance.76

A title insurance policy is divided into four categories: 1) Insuring provisions; 2)

Exclusions from coverage; 3) Schedule A, detailing to whom and to what the insurance policy

applies; 4) Exceptions from coverage; and 5) Conditions (i.e., the terms of contract between the

insurer and insured). Unless a buyer is comfortable with the title commitment, he should

purchase title insurance.

E. Survey

Obtaining an accurate survey of the property as part of the purchaser’s due diligence is

necessary in order to ensure that the purchaser is receiving what she is bargaining for. When

reviewing a survey, take note of the following:

• Calls – statements of "course and distance representing a particular boundary line on the survey”77

• Curves – curved lines, intersections between curved and straight lines, angles of curved lines and critical elements of curved liens.

• Field notes – the surveyor’s notes from the survey made on the ground. • Closure – the formation of a geometrical from by connecting the liens of the survey; it

is a measure of exactness. • Metes and Bounds – “the boundary lines of land with their terminal points and

angles. Metes and bounds may consist of course, distance, calls for joinder, calls for natural objects bounding a tract, such as gullies, streams, lakes, or bays, or even artificial monuments or objects, such as railroads, roads, fence lines and the like.”78

A buyer should always request a current on the ground survey when purchasing real

property as part of the business. It is important to confirm that property the seller is

74 TEX. INS. CODE ANN. § 2501.003 (West 2013). 75 Koenig v. First American Title Ins. Co., 209 S.W.3d 870 (Tex. App.—Houston [14th Dist.] 2006, no pet.). 76 First Title Co. of Waco v. Garrett, 860 S.W.2d 74, 76 (Tex. 1993). 77 Texas Title Insurance 2d § 7:18. 78 Id.

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representing to own is the property actually being conveyed. Failure to do so could result in

costly litigation or reduction of property size in the future.

F. Environmental Assessment

Under the federal Comprehensive Environmental Response, Compensation and Liability Act

(CERCLA)79, a property owner may be liable for the cost of cleanup of hazardous substances,

unless the property owner makes “all appropriate inquir[ies].”80 Therefore, an environmental

assessment must be a component of a purchaser’s due diligence.

G. Leases: Assignments and Subleases

When purchasing the business, its physical location may be located in a leased space and

not an owner-occupied building. Although purchasing a business that does not include the

purchase of real property has its cost advantages, issues may arise regarding the assignment

or breaking of the lease.

The Texas Property Code prohibits transferring a leasehold interest during the term of the

lease without prior consent from the lessor.81 Lessor may waive this right by agreement.82 An

assignment is a transfer of a lessee’s entire interest.83 In contrast, a sublease is a transfer of

anything less than a lessee’s entire interest—that is, if the lessee retains any reversionary

interest, the transfer is a sublease.84 Texas Property Code § 91.005 applies to both subleases

and assignments. A lessor has to duty to consent to a transfer, unless such a duty is created by

the lease agreement.85 If the landlord is willing to consent to the assignment, the buyer must

thoroughly review the lease terms and duration and require that the landlord provide

documentation confirming the seller is not currently in default under the lease. If the landlord is

79 42 U.S.C.A. § 9607(a). 80 42 U.S.C.A. § 9601(35)(b). 81 TEX. PROP. CODE ANN. § 91.005 (West 2013). 82 718 Associates, Ltd. v. Sunwest N.O.P., Inc. 1 S.W.3d 355, 363–364 (Tex. App.—Waco 1999, pet. denied). 83 Nottingham Manor Owners v. El Paso Elec., 260 S.W.3d 186, 197 (Tex. App.—El Paso 2008, no pet. history). 84 Twelve Oaks Tower I v. Premier Allergy, 938 S.W.2d 102, 113 (Tex. App.—Houston [14th Dist.] 1996, no writ). 85 Trinity Prof’l Plaza Assocs. v. Metrocrest Hosp. Auth., 987 S.W.2d 621, 625–626 (Tex. App.—Eastland 1999, pet. denied).

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unwilling to grant an assignment or sublease, then a buyer must be weary when purchasing just

the assets as the landlord may have a lien on all the property contained in the lease space.

IV. SECURITY AND PLEDGE AGREEMENTS

A. Security Agreements

Security agreements are important, especially in seller-financed transactions. A security

agreement is a an “agreement that provides for a security interest.”86 In other words, a security

agreement allows a seller who has financed the sale of the personal property assets of the

business, to secure the debt with those assets as collateral. A security agreement in essence

works the same as a deed of trust, if the buyer fails to make payments or defaults under the

loan documents then the secured party, the seller in this case, can judicially foreclose the lien

and take back or sell the assets. In order to make the security agreement valid and enforceable,

the seller must have attachment, perfection and priority.

i. Attachment

“A security interest attaches to collateral when it becomes enforceable against the debtor

with respect to the collateral.”87 A security interest becomes enforceable against the debtor

when “value has been given . . . the debtor has rights in the collateral or the power to transfer

rights in the collateral to a secured party . . . and the debtor has authenticated a security

agreement that provides a description of the collateral . . . ” or takes possession or control of the

collateral.88

ii. Perfection

Perfection puts other would-be creditors on notice of an existing security interest.89 The

type of collateral determines the method of perfection. A creditor can perfect a security interest

by complying with the statutory requirements set forth in the Texas Business and Commerce

Code sections 9.310–9.316. The dominant method of perfection is filing a financing statement

86 TEX. BUS. & COM. CODE ANN. § 9.102(74) (West 2013). 87 TEX. BUS. & COM. CODE ANN. § 9.203(a) (West 2013). 88 TEX. BUS. & COM. CODE ANN. § 9.203(b) (West 2013). 89 Official Comment 2 to UCC Section 9-308.

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with the Texas Secretary of State containing the name of the debtor, name of the secured party,

and a description of the collateral.90 This is known as a UCC-1 financing statement.

iii. Priority

In a contest between competing security interests in the same collateral, the first creditor

to perfect wins — the “first in time, first in right” rule.91 Upon default by the debtor, the secured

party may generally “reduce a claim to judgment, foreclose, or otherwise enforce the claim,

security interest, or agricultural lien by any available judicial procedure.”92

B. Pledge Agreements

Pledge agreements can be a creative method of securing the indebtedness in a seller-

financed transaction. A pledge agreement is a type of security agreement in which a pledgor

debtor delivers the collateral to the pledgee creditor to hold and take possession.93 Legal title

remains with the pledgor debtor, the pledgee takes a lien on the pledged collateral, and the

pledgor maintains a right of redemption after default.94 A financing statement is not required to

perfect pledge agreement—taking possession or delivery of collateral is sufficient.95 Manual

delivery is not required; constructive delivery is sufficient.96 The Texas Finance Code applies to

pledge agreements. Of particular relevance is title 4, subtitle b, which governs loans and

financed transactions; for example, section 346.101 sets the maximum interest rate of revolving

loan at 18 percent.97 Commonly, pledge agreements involve intangible personal property (e.g.,

certificated

90 TEX. BUS. & COM. CODE ANN. §§ 9.502(a), 9.516(a) (West 2013). 91 TEX. BUS. & COM. CODE ANN. § 9.322(a)(1) (West 2013). 92 TEX. BUS. & COM. CODE ANN. § 9.601(a) (West 2013). 93 Coffey v. Singer Asset Fin. Co., L.L.C., 223 S.W.3d 559, 566 (Tex. App. Dallas 2007). 94 Id.; First Nat'l Bank v. McCamey, 130 Tex. 148, 152 (Tex. 1937). 95See TEX. BUS. & COM. CODE ANN. § 9.313(a) (West 2013) (delineating different methods of perfection for different types of collateral). 96 Bullock v. Foster Cathead Co., 631 S.W.2d 208, 210 (Tex. App. Corpus Christi 1982). 97 TEX. FIN. ANN. § 346.101 (West 2013).

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and un-certificated securities).98 A pledgee assumes a large amount of risk by taking possession

or delivery of the pledgor’s collateral.99 As such, pledgees often enlist banks or other financial

institutions as escrow agents to hold the pledgor’s collateral.

V. ESCROW AGREEMENTS

“An escrow agreement is a contract formed for the purpose of preserving funds so they will

be available for disbursement when payment is authorized.”100 For a transaction involving real

property, an escrow arrangement cannot be created unless a written sales contract exists.101

The buyer deposits the purchase money with the escrow agent, a neutral third-party, who holds

the money “until the performance of a condition or the happening of a certain event,”102 after

which the escrow agent delivers the money to the seller. An escrow agreement must satisfy all

the elements of a valid contract.103 But escrow agreements are not subject to the statute of

frauds.104 The escrow agent must be a neutral third-party—he or she cannot be an agent of any

party to transaction.105 The escrow agent’s authority is defined entirely by the escrow

agreement.106 The escrow agent is liable for any wrongful or unauthorized delivery.107 An escrow

agent owes the parties to the transaction a fiduciary duty.108 In an action against an escrow

98 See TEX. BUS. & COM. CODE § 8.102(a)(4) (certificated securities); TEX. BUS. & COM. CODE § 8.102(a)(18) (uncertificated securities). 99 TEX. BUS. & COM. CODE ANN. §§ 9.207, 9.625 (West 2013). 100 EMC Mortgage Corp. v. Jones, 252 S.W.3d 857, 868 (Tex. App. 2008). 101 Simpson v. Green, 231 S.W. 375, 378–379 (Comm. App. 1921, holding approved). 102 Campbell v. Barber, 272 S.W.2d 750, 753 (Tex. Civ. App. 1954). 103 La Roe v. Davis, 333 S.W.2d 222 (Tex. Civ. App.—Amarillo 1960). 104 Starkey v. Texas Farm Mortg. Co., 45 S.W.2d 999 (Tex. Civ. App.—Waco 1932, writ ref'd); Upham v. Banister, 44 S.W.2d 1014 (Tex. Civ. App.—Amarillo 1931). 105 Covert v. Calvert, 287 S.W. 117 (Tex. Civ. App.—Amarillo 1926); Starkey v. Texas Farm Mortg. Co., 45 S.W.2d 999 (Tex. Civ. App.—Waco 1932, writ ref'd). 106 Trahan v. Lone Star Title Co. of El Paso, Inc., 247 S.W.3d 269 (Tex. App.—El Paso 2007), review denied (Oct 17, 2007); Chapman Children's Trust v. Porter & Hedges, L.L.P., 32 S.W.3d 429 (Tex. App.—Houston [14th Dist.] 2000, pet. denied), distinguished by Home Loan Corp. v. Texas American Title Co., 191 S.W.3d 728, 733 (Tex. App.—Houston [14th Dist.] 2006), review denied (Jun 01, 2007). 107 Houston Land & Trust Co v. Hubbard, 85 S.W. 474 (Tex. Civ. App. 1905); City Nat. Bank of Dallas v. Grimm, 262 S.W. 197 (Tex. Civ. App.—Dallas 1924, writ ref'd). 108 Trahan v. Lone Star Title Co. of El Paso, Inc., 247 S.W.3d 269 (Tex. App.—El Paso 2007), review denied (Oct 17, 2007); Chapman Children's Trust v. Porter & Hedges, L.L.P., 32 S.W.3d 429 (Tex. App.—Houston [14th Dist.]

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agent for breach of fiduciary duty, the escrow agent is liable for compensatory and exemplary

damages.109 Escrow agreements are important because they allow the parties to deposit

necessary funds with a third-party while due diligence is conducted by both parties and provides

the seller with some assurances that the buyer has serious interest in consummating the

transaction.

VI. CONSULTING AND INDEPENDENT CONTRACTOR AGREEMENTS

When purchasing a business it is important that the transfer of ownership is seamless and

the business continues to run at optimum performance. In order to accomplish this task it is

sometimes necessary to retain key personal or employees for a period of time after the sale. If

so, the buyer should negotiate these terms during the drafting of the purchase agreement and

make any consulting agreement or independent contractor agreements exhibits to the purchase

agreement.

During the negotiations, a buyer may be able to negotiate a smaller number if consulting

hours from the previous owner is to be included in the purchase price. Nonetheless, it is

important that the buyer distinguish between those people the buyer wishes to keep on as

employees and those which will be kept on as consultant or independent contractors for the sole

purpose of transition. If a person is to be kept on for the sole purpose of “transition” it is best to

make them independent contractors and sever the employee-employer relationship for purposes

of cost and liability.

VII. CONCLUSION

Buying or selling a business at any time can be complex and time consuming. However,

during uncertain financial times the complexities can be amplified. As such, buyers and sellers

must find creative and cost effective ways to complete the transaction, all while making sure

there interests are protected. It is important that buyers and sellers not forgo important

documents and due diligence procedures, but instead find creative ways to afford them.

2000, pet. denied), distinguished by Home Loan Corp. v. Texas American Title Co., 191 S.W.3d 728, 733 (Tex. App.—Houston [14th Dist.] 2006), review denied (Jun 01, 2007). 109 Capital Title Co., Inc. v. Donaldson, 739 S.W.2d 384 (Tex. App.—Houston [1st Dist.] 1987).