M&A and Alcohol: Don’t Let Regulatory Red Tape Leave Your Deal With a Hangover
Arielle Albert and Brian Fink highlight some important considerations and legal obstacles that investors face when buying and selling businesses with interests in alcohol licenses.
Mergers and Acquisitions By Arielle Albert and Brian Fink
In the world of mergers and acquisitions, target businesses are often a complex mix of different enterprises. Those who regularly practice in this area create “due diligence” procedures in order to make certain they do not run afoul of the many legal landmines buried inches below the surface. When a target business is involved in any portion of the hospitality industry, these dangers increase exponentially.
Though beverage alcoholic licensing issues may spring to mind if the key enterprise involves a manufacturer, wholesaler, retail bar or liquor store, similar issues will arise in many other businesses, such as hotels, resorts, restaurants, logistics companies, entertainment venues, supermarkets, gas stations, and the list goes on. Failure to comply with beverage alcohol regulations could jeopardize key assets that makes the target so valuable: its beverage alcohol licenses.
The chances for error are numerous and can occur at various points in the deal. At the outset, in the due diligence phase, Buyer’s attorney may fail to uncover past violations or other liabilities related to beverage alcohol laws.
At the drafting stage, neglecting to consider licensing issues can severely disrupt the anticipated timeline for the transactions. Depending upon the jurisdiction, obtaining a license can take between four and nine months. Just imagine having a contract with a clause that allows Seller to cancel if Buyer does not close within 90 days and then finding out that it will take six months to obtain regulatory approval of the transaction.
At the post-closing stage, by failing to timely notify regulators of changes to a business’s ownership or exercising control without permission from the regulating agency, the purchaser puts these licenses at risk of penalty, suspension, or revocation.
Many of these liabilities can be avoided. This article will highlight some important considerations when investing in licensed businesses.
The Regulated Supply Chain
Federal law regulates the production, importation, and wholesale distribution of alcohol. Wine, beer and spirits are each subject to different statutes and regulations. The business relationships in the alcohol supply chain are also subject to myriad federal laws and regulations. The Alcohol and Tobacco Tax and Trade Bureau, also known as the TTB, and, to a lesser extent, the Food & Drug Administration, are the federal agencies tasked with regulating the alcohol marketplace.
Empowered by the Twenty-first Amendment, states regulate the production, import and wholesale distribution of alcoholic beverages within their borders as well as the retail sale of alcohol for on- or off-premises consumption. These laws vary significantly from state-to-state. Sometimes they complement federal laws and other times they place additional requirements on top of them.
Federal and state regulations are extensive and complex, so the explanation in this article is intended to provide an overview. It is not and cannot be a complete discourse.
For licensing purposes, the alcohol supply chain is typically divided into three tiers. Generally the first tier includes suppliers, manufacturer and importers. The second or middle tier is made up of wholesalers or distributors. The third and final tier comprises retailers. Federal laws and the laws of almost every state severely limit or restrict the financial and operational interests a person may have in businesses licensed in the first or second tier on the one hand and a business licensed in the third tier on the other. For the most part, investors must pick a tier and live within it. Concurrent interests in manufacturers and retailers are almost always prohibited.
As you navigate a transaction from due diligence, through its structuring phase, to the closing and beyond, it is imperative to understand the tier into which the target business falls and which restrictions are placed upon an entity in that tier by federal law and the law of the states in which the business operates and intends to operate once the deal is complete.
Due Diligence and Alcohol Licenses
Due diligence is the first major undertaking of a transaction. First, confirm the target company has all the necessary licenses and permits to operate in each jurisdiction where it conducts business. If the target company is a multistate chain of restaurants, each restaurant should have the requisite licenses, permits, and/or endorsements to operate in each jurisdiction.
Often restaurants must also have licenses or permits issued not just by the state but by a municipality, such as a city, county and township. If the target company is a distillery, you must confirm it holds the necessary state and federal licenses to manufacture distilled spirits. If the distillery sells its products in 30 additional states, you must confirm that it has the necessary permits or licenses that those states require.
The next critical undertaking is determining whether the licenses are in good standing with each relevant agency. This means that the licenses are not expired and have and will be timely renewed. This also means that they accurately reflect the method of operation of the target company.
An important aspect of investigating the status of a license is to determine where there is current or pending disciplinary charges that may result in its cancellation or suspension. Sometimes this information is available on public databases and other times you must specifically request it from an agency or Seller.
When the target company is a supplier of beverage alcohol (including manufacturers and importers), you must also do a thorough review of its distributing relationships in each jurisdiction. This is because many states have franchise laws, which prevent suppliers from terminating a wholesaler regardless of whether there is a written agreement between the parties. While the laws in each franchise state vary, as a general rule the supplier cannot terminate the wholesaler without “good cause.” The definition of “good cause” typically includes the bankruptcy or insolvency of the franchisee, assignment of assets of the franchise business to creditors, violation of laws related to the franchise business and conduct by the franchisee which materially impairs the goodwill associated with the product. “Good cause” generally does not include the sale of the target company and thus, franchise laws will generally obligate a supplier to continue its distributing relationships even though its ownership has changed hands. So, if Buyer is acquiring a brewery or other alcohol manufacturer, it must be informed of the distributing relationships it is taking on and be cognizant of the obstacles it will encounter should it wish to change these arrangements in franchise states.
The diligence obligations do not end with a review of the target’s licenses and relevant agreements. You should also confirm that all investors are qualified to hold an interest in the target business and that each is willing to disclose sensitive personal information in order to obtain licensing approval. As a preliminary matter, you should find out whether any investor has an interest in a business licensed in another tier. As already mentioned, an investor who has a minority interest in a supplier, such as a brewery, winery or distillery will generally be barred from having any interest in a restaurant chain with liquor licenses.
Finally, state and federal law have requirements that those who traffic in alcoholic beverage law be of good moral character. Many states will bar an investor with a prior felony from having an interest in a license. Thus, due diligence requires an inquiry to establish that each member of an LLC or shareholder in a corporation, as well as managers, directors and officers, will qualify to hold an interest in the licensed business. Moreover, these qualified investors must be willing to submit personal details about their lives and potentially their spouse’s lives.
Knowing well in advance whether the interested parties are qualified to hold an interest in a licensed business can save time, money and avoid catastrophic problems. Indeed, disclosure requirements are often onerous and mandate submission of personal and financial information on behalf of the applicant entity, owners, officers, directors, managers and sometimes family members. These disclosure requirements cannot be circumvented by way of holding corporations or other investment vehicles. When it comes to ownership and control, most state agencies look through the entities invested in the target company, seeking to qualify the human beings that will financially benefit and control the business.
Immediate and Long-Term Licensing Needs
After completing due diligence of the licenses, identify whether the contemplated transaction triggers legal requirements to obtain new licenses or seek approval of the transaction before closing. All of this can cause delay and almost certainly prevent any contemplation of a simultaneous-sign-and-close transaction.
States often break down into three categories: those that require advanced approval; those that require notice at the time of closing; and those that allow post-closing notification and licensing adjustments. Each state in which the target company operates should be identified early on as a pre-approval state, upon-closing state, or post-closing state.
For example, New York requires license holders to obtain pre-approval from the State Liquor Authority for all ownership changes. Delaware law provides that the commissioner may refuse approval of changes in the ownership, officers or directors, financial interest, or lease in connection with any license. Other states require businesses to apply for new licenses if they incur a change in ownership above a certain threshold. South Carolina, for example, requires a licensee to surrender its license upon any change in ownership resulting in a transfer of 25 percent or more of the licenses’ ownership interests.
Similarly, Minnesota law provides that a license may be transferred, “only with the commissioner’s consent. When a licensee is a corporation a change in ownership of more than ten percent of its stock must be reported to the commissioner within ten days of the change.” Still others, like Colorado, generally allow changes in ownership to commence without pre-approval but require applications for approval of the change to occur immediately after the closing.
Federal law also governs changes in ownership of licensed suppliers (including manufacturers and importers) and wholesalers requiring either the filing and approval new ownership prior to closing or submission of a new permit application within 30 days after closing. Failing to meet this obligation may result in the termination of the target companies’ federal permits—a death knell to any supplier or wholesale business.
As you can see, approval, notification and application requirements must be identified for all jurisdictions in which a business operates because these obligations are crucial to the transaction’s structure. Getting the green light from pre-approval states like New York and Delaware are likely to be a condition of closing while for post-closing states, cooperation between the parties may be a representation that survives closing to address licensing obligations.
These are just some of the most common legal obstacles that investors and law firms face when buying and selling businesses with interests in alcohol licenses. Flagging and addressing them early on can save both parties substantial time, money and headaches down the line.