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5.07 Executive Summary of Final Due Diligence FindingsEXECUTIVE SUMMARY OF FINAL LEGAL DUE DILIGENCE FINDINGS prepared for: ZAP CUSTOM MACHINERY, INC. NOVEMBER 7, 2000 PRIVILEGED AND CONFIDENTIALprepared by: THE REALLY BIG FIRM'S MERGERS AND ACQUISITIONS GROUP I. SCOPE OF WORK This memorandum summarizes the results of the legal due diligence investigation conducted by The Really Big Firm in connection with the proposed acquisition of Longshot Corporation ("Longshot") and its wholly owned subsidiary Longshot Express Limited ("LEL") by ZAP Custom Machinery, Inc. and certain affiliates (collectively, "ZAP"). Longshot and LEL are sometimes referred to collectively as the "Company." We have reviewed all of the materials provided to date by Longshot, Amera Bank Ventures ("Amera Bank Ventures") and Amera Bank Capital, Inc. ("Amera Bank Capital") (collectively, "Amera Bank"), and Joe Smith, L.L.P. ("Joe Smith, Attorneys"), legal counsel to Amera Bank. Note in this regard that on July ____, 20__ Amera Bank acquired Longshot from Tragic Magic, Inc. ("Magic") and its affiliate Magic Machine Company, Inc. ("MMC"). Hence, our client ZAP must deal directly with the current seller, Amera Bank. This executive summary is an abbreviated compilation of our review, highlighting only those elements we deemed critical in evaluating particular risks and areas of concern related to negotiating the contemplated acquisition. A comprehensive compendium of our investigation will be made available if requested. Also, please note that much of this investigation is incomplete since numerous requested materials have not been provided for our review to date. II. PRINCIPAL FINDINGS A. Litigation. A summary analysis of Longshot's material litigation (both pending and threatened) is attached hereto as Appendix I. That listing indicates that Longshot has a substantial number of pending and threatened lawsuits, a significant number of pending and potential workers' compensation claims, and numerous other claims including trademark and patent infringement claims, wrongful termination of employment claims, and pension claims. We requested of Joe Smith a summary of ongoing and projected legal expenses for these matters. However, Mr. Smith noted that, due to the recent commencement of the actions and the inherent unpredictability of case development and duration, he was unable to provide an estimate. Note that, according to the due diligence files, average annual litigation expense for Amera Bank through 1997 was $200,000.00. Future expense could differ and any uninsured damages awards would be in addition to this yearly total. Following is a summary of some of the relevant information collected to date: 1. Product Liability Cases. Longshot is a defendant in a number of product liability cases involving physical injuries to users of Longshot- produced machinery. According to the May 20__ BON Future Service, Inc. ("BON") report and representatives of BON, Longshot's insurance program provides occurrence-based coverage, with both a self-insured retention per occurrence and an aggregate stop loss that have varied from year to year. Where such information was available, we have included the insurance adjuster's or defense counsel's estimate of Longshot's risk exposure in each of these cases. Among these cases, we understand that the Marcus, Lively and Smother claims constitute what are thought to be the most serious exposures. 2. Personal Injury Cases (other than product liability). (a) Bom Claim. In July 1997, two Acme employees including Omar Bom were injured in New Mexico when an automobile driven by a Longshot employee in which Mr. Bom and another employee were riding was in an accident. As is clear from the summary of the matter set forth in the table constituting Appendix I, both the allegations concerning the conduct of the Longshot employee and the alleged injuries for at least Mr. Bom are quite serious. The demand letter presented by counsel for Mr. Bom suggests a settlement offer of at least $2 million ($1 million for gross negligence and $1 million more for future medical expenses, pain and suffering, loss of earnings, emotional distress, etc.). It does not mention the other individual who was injured. It is possible that the other passenger could make a separate demand, but we have no knowledge at present as to his or her injuries or litigation posture. Although information we received suggested the contrary, Henry Howard of BON (Longshot's insurance broker) represented in a telephone conference held on December 5, 20__ that the claim is in fact covered under a policy with BIG. Note, however, that to date we have no written evidence from BIG supporting this representation. ZAP must obtain such written evidence prior to closing the contemplated transaction. ZAP should also identify the name and address of the second passenger-and any injuries allegedly sustained by him or her-prior to closing. (b) Smuss Claim. On or about July 6, 1996, Tom Smuss was hit and injured by a car owned and driven by John Wayne. Smuss has alleged that Wayne was operating his vehicle as an agent, servant and/or employee of Longshot at the time of the accident. Tom Smuss is seeking compensatory damages for injuries sustained as well as for pain, disability and mental anguish and expenses incurred or to be incurred in connection with the treatment of such injuries. Tom Smuss' wife Linda seeks compensatory damages for mental anguish and emotional distress. Answers to interrogatories provided by Longshot indicate that Wayne was not in the course of his employment at the time of the incident, as supported by Wayne's time/expense report that showed no hours logged that day. 3. Patent and Trademark Infringement Cases. Existing and potential patent and trademark infringement claims include: (a) Instant Soda Topper (patent : by Cola) (b) Single faucet (patent: by WaterWorks) (c) Instant Soda Topper (trademark: by Mapp Equipment) (d) Instant Soda Topper (trademark: by Instant Equipment) We understand the Cola claim was decided in Longshot's favor, but the appeals period has not yet expired. Longshot entered into license discussions with WaterWorks based on the potential merit of its claim, but such discussions (and all other contact with the claimant) ended in 1993. This extended period of inactivity together with the relatively short remaining life of the patent at issue (expiring in 20__) suggest minimal exposure. We have requested and are awaiting further information on the trademark claims by Mapp Equipment and Instant Equipment. Based on the data provided, it is impossible to assess Longshot's exposure in these cases. 4. Other Claims. The schedule of pending and threatened litigation attached hereto as Appendix I includes several additional claims or potential claims including three wrongful termination cases (two based on age discrimination and one based on disability discrimination) as well as two potential breach of contract claims (one relating to termination and one to pension benefits) made by former Longshot employees. The potential breach of contract claims are, at present, directed to Magic and not to Longshot. B. Warranty Claims. Longshot provides six-month written warranties for its products, which was apparent from our review of a random sampling of Longshot customer contracts, the provisions contained in the standard purchase-order invoice form, and interviews with Joe Smith Attorneys. According to Joe Smith Attorneys, Longshot provides actual warranty service on a "good will basis" well in excess of such period. The Uniform Commercial Code in effect in most states provides that a manufacturer's course of conduct can modify or amend an existing contract, including express warranty provisions. Accordingly, Longshot's actual warranty exposure may legally exceed the six-month period set forth in its contracts. The adequacy of the warranty reserve should therefore be carefully assessed. C. Benefit Plans. We have reviewed certain employee benefit and executive compensation arrangements of Longshot and LEL as listed in Appendix II. Because the documents we have received generally appear in most cases to be the documents in effect at the time of the Amera Bank transaction, it is unclear whether many of the arrangements described are still in effect or whether they have been superceded. Most important, one of the plans which was merged to form the current defined benefit plan was apparently underfunded. A benefits consultant should be retained to assess with certainty the funding of the current plan and any shortfall in that funding. Longshot currently has approximately 190 salaried employees and in excess of 400 hourly employees, both in the United States and abroad. Domestically, these employees are entitled to participate in a number of company-sponsored plans, including those set forth in Appendix II. We have performed no analysis to date on employee benefits of non-U.S. employees. Our Maine office will be able to assist in this regard should ZAP so desire, and in such event, we should conduct a comprehensive due diligence investigation with the assistance of an independent benefits consultant. A summary of relevant issues is set forth below. 1. Employment, Non-Compete and Other Individual Agreements. Longshot has employment contracts with four of its top executives, the terms of which are fairly customary. We are now determining whether all the agreements reviewed are currently in force and have requested copies of various missing agreements. None of the agreements we have reviewed have successor clauses (which in any event would probably not be an issue since the proposed purchase is currently structured as a stock transaction). Also, the agreements of Harry S. Nelson and Frank D. Sutton were amended in July 20__ to include appropriate non-competition provisions. 2. Policies and Procedures Handbooks for U.S. Employees. Labor counsel should review handbooks for both salaried and shop employees so that all handbooks can be updated immediately upon closing of the proposed transaction. In particular, the shop employees' handbook does not appear to have been updated since 1990, and is likely to require significant modification to more accurately reflect current employment policies. 3. Qualified Plans. Longshot sponsors a defined benefit plan (a recent merger of two plans--one underfunded) and a defined contribution plan. We need a favorable determination letter for the defined benefit plan, as well as actuarial statements, a summary plan description, and the 1999 Form 5500 (we are in possession of the 1998 Form 5500; the 1999 form should have been filed recently). The funded status of the plan requires thorough review by pension benefits consultants since the underfunding of one of the two prior plans was a reason for their merger. We noted in the first Executive Summary that the Andersen Ernst Due Diligence Report (the "AE Report") stated that the pension plan is well-funded. We need a favorable determination letter for the defined contribution plan that was recently established, as well as a recent valuation and summary plan description. Since the defined contribution plan is the same as the prior plan, we should ascertain whether there was an asset transfer from the old plan to the new plan and if so, whether it was properly executed. 4. Deferred Compensation Plan. There appears to only be one deferred compensation plan. We are currently investigating whether that plan remains in effect and whether any additional arrangements of this nature exist. 5. Incentive Plans. We have not received confirmation about the status of current incentive plans. We have requested a list of such plans and, upon receipt of same, will review all plans and arrangements currently in place. 6. Welfare Plans. We have received minimal information about current welfare plans. Upon receipt of such information we will review all welfare benefit plans and arrangements currently in place. In the first Executive Summary we stated that Longshot sponsors post-retirement medical benefits and a "rich benefits package," but we have not received any further information on the former. In addition, we note that certain records in the data room describe certain future post-retirement medical benefit liabilities. There has been a fair amount of litigation regarding the modification or termination of such benefits, so if possible we should examine all past disclosures about such benefits to employees. We should also speak with someone at the Company regarding any internal review the Company may have conducted about the feasibility of amending or terminating such plans. 7. Foreign Employees. We must determine if LEL had entered into agreements with foreign employees to continue their employment following the acquisition of LEL's parent corporation Longshot, and should review any agreements which had been entered into since Longshot acquired LEL. We must also ascertain the status of agreements that various individuals had with Magic. All plans currently in force in connection with foreign employees should also be reviewed, preferably by foreign counsel or foreign employee benefit consultants. D. Labor Matters. Fortunately, Longshot's labor force is not represented by any labor union. However, certain employment law issues and potential liabilities are triggered by the reduction in work force which ZAP intends to undertake upon completion of the acquisition of Longshot. Such layoffs can trigger contract, race discrimination, sex discrimination or Worker Adjustment and Retraining Notification Act ("WARN") litigation, as discussed below. We therefore recommend that, in seeking to restructure Longshot's work force, ZAP consult with labor counsel to develop and implement a plan that retains the best-qualified employees while avoiding or minimizing unionization and/or litigation potential. The primary areas of exposure following merger down-sizing are as follows: 1. Discrimination Issues. Under the common law of almost every state employees are presumed to be hired "at will." Thus, absent a promise or contract to the contrary, both the employer and employee have the right to end employment at any time for any reason so long as the termination is not legally prohibited.1 As a result, the employer may freely terminate some or all employees based on need or other business reasons. Depending on employer policies and past practices, terminated employees may have certain severance pay rights. Moreover, when an employer terminates some but not all employees, the termination election procedure may be subject to review for evidence of discriminatory intent. Most claims of discrimination are based on one or more of the following: (a) Race, sex, national origin, religion (Title VII of the Civil Rights Act of 1964); (b) Age (Age Discrimination in Employment Act); (c) Disability (Americans with Disabilities Act); (d) An employee's exercise of medical or child/leave under the Family and Medical Leave Act and state workers' compensation and other laws. Given the age of Longshot's operation, we believe that the work force is both senior in years of service and in chronological age; thus, the primary legal concern vis-ˆ-vis lay-offs will be perceived age discrimination. The Age Discrimination in Employment Act of 1967 ("ADEA") prohibits employment discrimination against individuals who are age forty or older by firms with twenty or more employees. In the case of a reduction in work force, employees over age forty who are selected for lay-off may allege that their selection was due to their age. As a defense, the employer must be able to articulate a valid non-discriminatory reason for the discharge. We recommend consultation with labor counsel to assist in the development of a strategic lay-off plan which will minimize Longshot's exposure to age discrimination or other termination- related claims. Such plan should offer monetary incentives for voluntary early termination. 2. WARN Act Considerations. The Worker Adjustment and Retraining Notification Act generally requires that sixty days' advance notice of a "plant closing" or "mass lay-off" be given to affected employees, bargaining representatives, and local government officials. The Act, which contains complicated jurisdictional, triggering and notice obligations, would arguably be applicable only if a third or more of any department, division or facility is affected by a lay-off and when such lay-off actually results in a loss of work for fifty or more employees in such division, department or facility within any consecutive ninety-day period. Although there are exceptions and strategic nuances to the application of WARN, if the restructuring results in less than a fifty-person layoff, the notice provisions of WARN do not apply. If a lay-off of more than fifty persons is contemplated, it will be useful to analyze whether any restructuring or timing changes in the planned lay-off may allow the Company to avoid the necessity to give WARN notice. 3. Special Issues Under New Jersey Law. New Jersey has promulgated statutes which require compliance beyond those established under WARN. Under these laws, employers must provide a notice, similar to that required by WARN, to the state's Dislocated Workers Unit (the "Unit"). The Unit is then required to maintain a file of all notices and correspondence relating to the employer's action. Forty-eight hours prior to a mass separation (a separation of fifty or more employees from a single establishment for either a permanent or indefinite period of time and at or about the same time), the employer is required to file a notice with the local unemployment insurance claims office nearest to the affected facility. If an employer itself has no prior warning of a mass separation, the notice must be given within twenty-four hours of the separation.4. Immigration Matters. We need to ascertain whether immigration arrangements need to be made for foreign employees working in the U.S. E. Enforceability of Existing Representations, Warranties and Indemnities. Our analysis of the purchase agreement (the "Agreement") by which Amera Bank acquired Longshot from Magic and MMC suggests some uncertainty exists as to whether the representations, warranties and indemnification provisions of the Agreement are (or were) enforceable by Longshot against Magic. We believe that the representations, warranties and indemnifications of Smother (an on-the-job injury claimant) set forth in the Agreement should be held to accrue in favor of and be enforceable by Longshot either through (1) Longshot as an intended third- party beneficiary of the Agreement or (2) Longshot as successor-in-interest to all of the rights and benefits enjoyed by Longshot Acquisition Corporation ("LAC") under the Agreement. However, in order for this position to prevail, we must explain or defeat specific ambiguous or other potentially adverse language in the Agreement. A series of unfortunate errors (e.g., Longshot is a stated beneficiary of the Agreement but is not a signatory/party; and the use of the phrase "permitted successors and assignees" without defining what is "permitted") renders a conclusive determination of this issue impossible. Thus, the issue of whether Longshot will actually be able to enforce such provisions is at best unclear, and would be a question ultimately to be resolved by a judge or jury. Accordingly, we recommend ZAP consider seeking the following assurances: (1) Express acknowledgment by Magic that Longshot is entitled to enforce the Agreement. (2) An indemnification from Amera Bank which would only be triggered in the event Longshot was held not to have an enforcement right under the Agreement; and/or (3) An opinion of Joe Smith Attorneys as to matters of enforceability (plus copy of Joe Smith's Attorney's errors and omissions policy). F. Performance Guarantees. Most of Longshot's equipment sales appear to have been made pursuant to purchase arrangements. However, a number of sales have occurred according to financed lease arrangements. In the latter, Longshot has guaranteed leasehold payment streams, equipment repurchases or other obligations of the lessee. Attached as Appendix III is a list of Longshot's outstanding third-party guarantees as of September 17, 1998. We have requested an updated list, but neither Longshot, Amera Bank, nor Joe Smith Attorneys was able to provide any new information regarding any additional contracts of this nature. Neither we, Longshot nor Amera Bank has any way of knowing whether this list is complete given that Magic did not provide a listing that it represented and warranted as accurate and complete. Discussions with Joe Smith Attorneys suggests that this lack of certainty regarding the total number of such arrangements is related to the management problems that resulted in the financial irregularities which were the subject of the Andersen Ernst audit last year. Apparently, former Longshot management exceeded their authority in entering into such arrangements and contracts of this nature were never authorized by Longshot's former parent firm. As a result, there are no means available by which it can be determined whether Longshot is party to other contracts of this nature. Although it is impossible to quantify precisely the magnitude of exposure, the items listed on Appendix III aggregate in excess of U.S. $2 million in potential expense. In spite of Joe Smith Attorney's assurance that each such contract presents a fair buy-back amount for the subject machinery, ZAP will need to develop a better understanding of the credit risk of each relevant lessee and the full extent of financial exposure to Longshot.G. Environmental. Under applicable U.S. environmental laws and regulations, both owner and non-owner operators (including former owners and/or operators) can be held liable for releases of hazardous substances As a result, ZAP must be concerned not only about the existing Bunker facility owned by Longshot, but also Bunker's former facilities in Detroit and Jackson, as well as any other facilities it may have previously operated or owned. Following is a summary of the environmental condition of both current and former facilities, including information as to any indemnity benefits which may apply and the current regulatory status of each property, if applicable. We note that no information has been provided regarding the joint venture operations in Zurich or New Orleans: 1. Bunker Facility. Operations include the design and manufacture of machines used to produce and convert corrugated board packaging (machine-shop, warehouse, and machine-assembly area). (a) Environmental Condition. Based on a review of the documents provided, there do not appear to be significant potential environmental liabilities associated with this facility. Environmental consultants identified the following areas of concern: Former and existing underground storage tanks ("USTs"), although sampling does not suggest contamination; asbestos containing material ("ACM"), although abatement was successfully performed; floor drains, troughs, and sump pumps routed to a municipal sanitary sewer system, although the concrete appears intact; one previous minor dumping violation related to hazardous waste generation (waste oil, cutting fluid, paint, cleaning solvents); two previous minor water permit violations related to effluent flow and sampling of non-contact cooling water (settled for $10,000.00); and discrepancies related to "interim operating certificates" for ten air emissions points, although being worked out with the appropriate state agency. (b) Indemnity Rights. The indemnity rights in the Amera Bank purchase agreement from Magic with respect to breaches of representations/warranties are limited. Indemnification for breaches of representations/warranties for permit compliance are generally limited to damages over $30,000.00. Indemnification for environmental law breaches are generally limited to damages over $30,000.00 and to events occurring within the five years commencing _______ , 20__. Moreover, although the above limits apply to liability for hazardous conditions, the agreement excludes indemnification for remediation required as a result of such breaches. The general liability "basket" is $2 million and the general liability cap is $5 million. The general survival period for most such representations is eighteen (18) months from closing. (c) Regulatory Status. The transfer of Longshot from Magic to Amera Bank triggered the New Jersey Industrial Site Recovery Act ("ISRA"). Similarly, the transfer of Longshot from Amera Bank to ZAP must comply with ISRA. Pursuant to ISRA, certain facilities such as Bunker must obtain state agency certification prior to transfer of property. To obtain agency certification, the facility must submit a Preliminary Assessment/Site Investigation ("PA/SI"). Agency certification comes in two forms: (1) a No Further Action ("NFA") letter and (2) a Remediation Agreement. Due to agency backlog, it is sometimes difficult to obtain an NFA letter prior to sale even when such a letter could ultimately be obtained without difficulty. In the previous transfer, an environmental consultant assisted in the preparation of the PA/SI (July 7, 20__), and a request for an NFA letter was submitted. Due to time constraints, on July 25, 20__, the parties executed a Remediation Agreement instead. According to Joe Smith Attorneys, the Remediation Agreement provides that Magic will be obligated to perform any required remediation. We need to confirm this. Among other things, we need to determine: (1) what Amera Bank and ZAP must do to remain in compliance with ISRA (an environmental consultant may need to be retained by Amera Bank to certify that environmental conditions have not changed since the submittal of the PA/SI); (2) whether Magic remains bound by the first Remediation Agreement; and (3) what remediation remains to be done. The previous agreement contained a covenant that Longshot would be obligated to remove the remaining two USTs if ordered by the state agency. Note that in the Amera Bank/Magic purchase and sale agreement, Magic agreed to provide Amera Bank with clearance under ISRA, or, where clearance could not be obtained, Magic agreed to be identified as the sole party responsible for remediation. It is important that ZAP receive a similar covenant from Amera Bank. The prior indemnification provides the buyer up to $6 million (with no basket) for liability associated with ISRA. 2. Detroit Facility. Longshot previously occupied this site but no longer owns it, nor does it conduct operations at the site. However, Longshot has potential liability for environmental remediation as a prior operator. Following is a brief overview of relevant information concerning this site. (a) Environmental Condition. There is on-going remediation at the Detroit facility. The primary environmental concerns are an underground benzene plume, a former drum area, and ground-water contamination (including the recent detection of the volatile organic compound MTBE, which suggests an off- site source). An environmental consultant has estimated remediation costs at $70,000.00 to $350,000.00-depending primarily on whether the state agency accepts natural attenuation as a method of remediation. (b) Indemnity Rights. Assuming ZAP receives indemnity rights comparable to those received by Amera Bank in the previous transfer, ZAP would be indemnified up to the Amera Bank purchase price for environmental liability associated with the Detroit facility. (c) Regulatory Status. We understand that Magic intends to sell the facility to the poultry company that currently leases the site. To sell the Detroit facility to the poultry company, Magic must comply with ISRA. Pursuant to ISRA, Magic has apparently entered into a remediation agreement with the state agency which provides that Magic retains any environmental liability for the Detroit site and that the agency will look only to Magic as the responsible party. When it purchased other Longshot assets from Magic, Amera Bank sent a notification letter to the state agency that no correspondence relating to the Detroit facility should be sent to it at Bunker or elsewhere. ZAP should similarly notify the state agency that it never has and will not have any connection with or liability for the Detroit facility if it proceeds with this transaction.3. Jackson Facility. This formerly leased facility is now closed. Because Longshot never owned, but only operated the site, Longshot's potential environmental liability should be limited to on-site contamination, if any, attributable to Longshot's operations. (a) Environmental Condition. A data-base search performed by an environmental consultant concluded that the only environmental concerns were possible leaking USTs from nearby facilities which were never under the control of Longshot. Hence, Longshot should have no liability associated with those UST's. (b) Indemnity Rights. The Jackson facility is not mentioned in the previous indemnification provisions. Longshot likely has limited, if any, potential liability associated with the Jackson site. (c) Regulatory Status. Not known at this time. H. Accounting Irregularities. As has been noted at some length in the bid book, the AE Report, and various other contexts, Longshot underwent a financial investigation and special audit as of March 1998. This investigation and audit was the result of a "tip" from a former employee that significant irregularities were present in Longshot's financial reporting. As a result of that investigation, a write-down of approximately $17,571,000.00 was taken, senior management was replaced, and new controls were implemented. We wish to note the following: The Agreement contains no indemnity clause against any liabilities incurred in connection with the financial irregularities, except as they may result from claims or counterclaims by Master Works, Inc. or former employees. Accordingly, Longshot has no third-party recourse regarding other potential related claims. At present, we do not envision a scenario whereby Longshot or ZAP would be subject to liability related to these financial irregularities. However, additional analysis of the situation should be undertaken to determine with certainty whether any third-party claims or other exposure is possible. The potential tax exposures relating to this situation are discussed in Item N below. I. Required Refinancing. Longshot currently is party to a $50 million Loan and Security Agreement ("Loan Agreement") with Rapid Capital Corporation ("Rapid"). The Loan Agreement provides for a $20-million term loan (5-year term at LIBOR plus 300 basis points) and a revolver which, subject to borrowing base and other limitations, provides for up to $30 million in aggregate availability (5-year term at LIBOR plus 250 basis points). Although we can summarize the Loan Agreement if ZAP requests same, under Section 10.2.12 (Change of Ownership) of said Loan Agreement, should Amera Bank Ventures, Inc. "cease to own and control beneficially and of record at least 51% of the capital stock of Holding, and Holding shall cease to own . . . 100% of . . . Borrower," then a default shall have occurred. As a result, the contemplated transaction will require either the consent of Rapid, the amendment of the Loan Agreement, or the refinancing of the Rapid loan. Please therefore advise whether you wish us to prepare a further analysis of the Rapid Loan Agreement. J. Intellectual Property. Attached hereto as Appendix IV are brief summaries of the patent and trademark information compiled to date. Based on our discussions with Joe Smith Attorneys, it appears that only limited due diligence was exercised relative to the patent portfolio, Amera Bank electing to rely more upon the representation and warranty of Seller in the Share Purchase and Sale Agreement. That representation includes a statement that, "to Seller's Knowledge, the use of such [intellectual property] does not infringe on the rights of any person." Such representation and warranty expires eighteen months after the closing of the purchase by Amera Bank, and is subject to the $2 million basket and $6 million cap.Joe Smith has advised us that its limited analysis and concerns in this area reflected Amera Bank's view that Longshot's intellectual property had no value. To the extent that ZAP does not share this view (i.e., to the extent that ZAP believes Longshot's intellectual property to be valuable), additional due diligence regarding the quality of the patents and the validity of the pending or potential patent infringement claims of WaterWorks and Cola would be in order. We must ensure that title to the listed properties can be transferred in connection with the proposed acquisition. We further note that Magic has filed an opposition to the registration of the mark "LONGSHOT COMPANIES, INC." as used in connection with tarpaulins and other textile materials. Further, our investigation revealed that a document styled as an "Agreement Not to Interfere" was recorded in the U.S. Patent and Trademark Office in conjunction with such opposition so that we must now determine whether there are any limitations regarding the use of the "LONGSHOT" trademark. In addition, several patents and trademarks apparently owned by Longshot or related entities do not appear in the diligence documents (i.e., U.S. Patents Nos. 1,000,000 and 1,000,001, British Patents Nos. 1,000,002 and 1,000,003, and U.S. Trademark Registrations Nos. 1,000,004, 1,000,005 and 1,000,006 for the marks MULCH EATER, respectively). We should determine why such properties were not identified and whether there are any other unidentified similar properties. Also, are any pending applications still being maintained in secrecy? K. Insurance Coverage/Risk Management. We have reviewed most of Longshot's previous insurance contracts, as well as a report and insurance certificate from BON summarizing Longshot's current coverage. BON's March 20__ analysis of Longshot's insurance position and risk posture describes Longshot's exposure to "catastrophic loss" risk as "moderate," while Longshot's risk regarding ordinary fire loss is high given Longshot's single manufacturing location. This is an area that will require additional analysis by ZAP's insurance and risk management specialists as ZAP and Amera Bank proceed toward a closing. ZAP requires a balanced and responsible risk management program in place at closing. Attached as Appendix V is a summary of policy information provided by BON. L. Information Technology and Management Information Systems. The AE Report provides a good overview of systemic problems with The Company's management information systems. The Report also notes that Longshot's IT expenses of approximately 2% of revenues is well below average, which approximates 5% to 7%. This situation should be further investigated to assess the adequacy of IT expenditures and to ensure no material increases in expenditures are expected. Moreover, the AE Report does not address licensing issues that may be relevant. In a change of control transaction such as the one just completed (and the one contemplated with ZAP), it is not uncommon in both the U.S. and the U.K. for at least some software and systems licenses to contain termination or renegotiation provisions. If those agreements do contain such clauses, there may be existing technical defaults and a need for consents, which may involve additional expense. We must determine if the prior sale triggered any technical defaults and related required consents which were not obtained prior to closing as well as whether the contemplated new purchase will result in a need for additional consents.M. Financial and Operational Matters. We performed no financial or operational due diligence. N. Tax Matters. Our preliminary due diligence findings were previously reported in a Memorandum dated October 26, 20__, and were supplemented by subsequent memoranda dated October 30 and 31, 20__, respectively. In general we note no tax-related issues of sufficient magnitude to prevent ZAP from proceeding with the proposed transaction. The more salient points of our investigation are summarized below: 1. Section 449(i)(11) Allocations. Pursuant to Section 9.21 of the Amera Bank Agreement, MMC and LAC were to make an election under Section 449(i)(11) (and any corresponding elections under state or local tax law) with respect to the sale and purchase of the Longshot shares. Such election would ensure that Longshot will be treated immediately prior to the transfer for income tax purposes as if it sold all of its assets for fair market value, and will then be treated the day after the transaction as a new corporation which purchased all of the assets. The Amera Bank Agreement provides that the parties will agree to the allocation of the consideration attributable to the Longshot shares in accordance with Section 2171, and that MMC will be responsible for all taxes arising from the Section 449(i)(11) election. The Section 2171 allocation is relevant because Longshot's basis in the assets that it held as of the date of the share purchase is determined by the allocation. To the extent that the parties to a transaction agree in writing as to the allocation of consideration, Section 2171 provides that such agreement generally is binding on both parties. We have been informed that the parties are currently in the process of determining the fair market values of the assets and negotiating the Section 449(i)(11) allocations. 2. Tax Indemnities. The Amera Bank Agreement contains two sections relating to indemnification for taxes: Article VI, which deals with indemnification in general, and Article VII, which specifically addresses tax matters. Under Article VII, Magic and MMC indemnify LAC and Longshot against liability for all "Taxes" owed by Magic, MMC or any of their affiliates (except Longshot) for any taxable period. This indemnity is limited to an amount equal to the purchase price. "Taxes" includes income taxes as well as sales, use, payroll, withholding and other types of taxes. Under Article VIII, however, Longshot and each of its affiliates are indemnified by Magic and MMC against unreserved liabilities for all unpaid taxes of Longshot for taxable periods ending on or before December 31, 1998. However, for the period after December 31, 1998 through the closing date of the share purchase, the indemnification extends only to income taxes of Longshot. Thus, for such period, LAC and Longshot are exposed to liability for sales, use, payroll, withholding and other non-income taxes owed by Longshot (see the sections below dealing with non-income tax liability exposure). Do you want to request that Amera Bank provide the ZAP shareholders with an indemnity for any such taxes? As noted in Section 3 below, payroll tax liability in particular is a potential issue. As noted in Item E, above, whether such representations, warranties and indemnities will be enforceable by Longshot against Magic cannot be determined with certainty. Finally, we note that the value of any tax indemnity is dependent upon the credit worthiness of the indemnitor. In light of the ambiguities and incomplete reach of the indemnification provisions in the Amera Bank Agreement, we suggest that specific provisions for indemnity from Amera Bank with respect to the contributed Longshot stock be included in the sale agreement even though ZAP has not requested such an indemnity at this time. 3. Federal Payroll Tax. The AE Report stated that since Longshot indicated it had not been subject to any federal payroll tax audits in the last twenty years, it was difficult for AE to determine potential exposure on payroll tax issues. Consequently, no figures as to risk were given. However, AE did note that the potential for significant exposure existed. Again, subject to the previous discussion relating to tax indemnities, these amounts (for periods before January 1, 20__) should be covered by indemnities under the Amera Bank Agreement. 4. Sales and Use Taxes. According to the AE Report, Longshot was under audit by the state of Minnesota for the 1994-1998 tax years, and the auditor indicated there would be only a small assessment. Longshot indicated that a MASTER WORKS, INC. report identified a high-risk exposure of approximately $323,000.00 and a low-risk exposure of $326,000.00 for these tax years. We are now awaiting AE's estimates of state sales and use taxes for post- 1998 taxable periods. Again, subject to the discussion relating to indemnities, these amounts should be covered by indemnities under the Amera Bank Agreement. At the time of the sale, Longshot was working with MASTER WORKS, INC. to properly register to pay state sales and income taxes in a number of different jurisdictions. We understand Longshot is currently making voluntary disclosures and filing returns with various states and is negotiating amounts to be paid in connection with a variety of state sales and use taxes. 5. State Income Tax. The AE Report states that MASTER WORKS, INC. performed a state income tax analysis and concluded that the high-risk exposure was $259,000.00, the medium-risk exposure $223,000.00, and the low-risk exposure $32,000.00. We are now awaiting AE's estimates of state income taxes for post- 1998 taxable periods. Again, subject to the discussion relating to indemnities, these amounts should be covered by the indemnities under the Amera Bank Agreement. We understand Longshot is currently making voluntary disclosures and filing returns with various states, and is negotiating amounts to be paid in connection with various kinds of state income. O. Foreign Joint Ventures. The files we reviewed regarding foreign joint ventures are incomplete and no local counsel was retained in any of the relevant foreign jurisdictions. Accordingly, there has been no analysis of whether local filings and/or consents are required or whether the agreements are enforceable. We recommend that local foreign counsel be retained as necessary to provide advice.