Tip of the Week: The Claim Left Behind

At times in a reverse merger the shell being examined (assuming it is a “legacy” shell with a history of operations) has what appears to be an asset, in the form of a claim or lawsuit against a third party. With diligence you may even be able to determine that the claim is real, legitimate and could bring meaningful reward to the company. At the time of the transaction either the shell did not have enough money to pursue the claim, or there is a litigation in process that still has a ways to go. The common reaction in this situation is, “Why not?” It would seem a no-brainer to keep and possibly even pursue the claim after the reverse merger.

Two questions arise in this situation: the first is, if you do want to keep the claim, does the shell have the right to count the value of the claim towards valuing the shell as a whole? In general, I believe the answer should be no. There may be situations where a potential claim is so significant, or appears to be so clearly black and white, that an argument could be made to add it to the value. But in most cases this is not likely to be the case.

The second more important question is, are you sure you want it? The seeming no-brainer is not so simple in fact. If no claim has been pursued, there may be little risk if it is never pursued. But if a litigation is ongoing, or if the intention is to start one, there is risk for sure. In one case, there was a litigation against a former CEO of the shell for conversion, or theft of company property, in the amount of several hundred thousand dollars. It appeared that the evidence was clear, and in fact the executive had admitted the theft as part of a settlement of a related criminal action. So why not continue it, especially since the lawyer had agreed to take it on a contingency?

Several reasons not to. First, even with a lawyer on contingency, expenses in these situations are still charged to the client, and as trial comes closer, those expenses can be significant indeed, whether for experts, jury consultants and the like. Second, it is possible the former CEO has some sort of counter-claim against the company. Maybe he did steal, but that was only because he was wronged in some way by the company. Once that counterclaim is brought, you cannot simply withdraw the case if you are unhappy. Last, and in some ways most important, even if you bring the case successfully to trial and win with minimal expenses and no counterclaims, you have to know whether you can collect from the defendant. Even if you believe the defendant has resources, they may be hidden or tied into entities that cannot be touched.

So be careful if a shell is offering what appears to be free money in a claim left behind.

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