Fill and Sign the Executive Summary of Preliminary Due Diligence Findings Form

5.06 Executive Summary of Preliminary Due Diligence FindingsEXECUTIVE SUMMARY OF PRELIMINARY LEGAL DUE DILIGENCE FINDINGS prepared for: MONDO DISMO, s.p.a.SEPTEMBER 30, 2000 PRIVILEGED AND CONFIDENTIAL prepared by: THE REALLY BIG FIRM'S MERGERS AND ACQUISITIONS GROUP I. SCOPE OF WORK This memorandum summarizes the results of the Phase One legal due diligence investigation conducted in the offices of Pac Tort 21, Inc. ("Pac 21") on September 24, 2000, and certain direct and telephonic interviews conducted during and after that time period, all relating to the possible acquisition of Pac 21 by Mondo Dismo, s.p.a. or its affiliate ("Dismo"). Our Phase One investigation was part of a larger preliminary due diligence effort, including an investigation by Dismo's independent accounting firm Arthur Ernst. Our work was conducted on an abbreviated time table for the purpose of assisting Dismo in determining whether to proceed beyond the letter of intent stage with respect to the proposed acquisition of Pac 21. Accordingly, our procedures were limited both in scope and in character, and did not extend beyond: (1) review of the documents made available to us in the Pac 21 offices and (2) interviews with the members of management listed on Schedule I and retained advisors listed on Schedule II. Should Dismo elect to continue with the possible acquisition of Pac 21, additional legal due diligence will be required in connection with the negotiation and execution of definitive purchase and sale agreements and the closing of the transactions contemplated thereby. II. PRINCIPAL PRELIMINARY FINDINGS A. Overview. As with many privately held companies with limited revenues, resources and employees, Pac 21 lacks a certain level of sophistication and organization with respect to its corporate and legal records. This situation is also likely to apply to other areas such as operations and finance. Although this is not uncommon, it does mean that finding all the "trouble spots" through pre-closing legal, financial, operational and other due diligence procedures is unlikely, and that effective, enforceable representations, warranties and indemnifications should be included in the preliminary draft to protect Dismo. In addition, it is our recommendation that a significant portion of the purchase price or other consideration paid in connection with the transaction be withheld for no less than eighteen (18) months after closing. During such post-closing period, it is likely that many of the issues or problems that may not have been uncovered in due diligence will arise, and therefore the escrow or purchase price reservation arrangement will provide a recourse to Dismo. B. Corporate Records. According to its records, Pac 21 was organized as a Massachusetts corporation in June of 1974. However, its corporate record books contain no references whatsoever to meetings and other corporate formalities until February 1, 1988. It will be important for Dismo's accounting due diligence team to ensure that there are no accrued tax liabilities, governmental penalties or other related financial or accounting liabilities resulting from this approximately ten-year breach of normal record-keeping protocols. For example, Massachusetts requires various annual filings (statements of condition) by corporations. There is nothing in the records we reviewed to suggest that any of these formalities were complied with. Accordingly, the accounting and tax due diligence team of Arthur Ernst will need to help quantify any exposure here. Moreover, the lack of yearly statements of condition could have resulted in an automatic dissolution of Pac 21 by the Massachusetts Secretary of State plus assessments of overdue corporate excise taxes, interest and/or penalties.C. MBE Status. According to the records made available to us, Pac 21 currently has seven shareholders, four of whom were represented by management to be Native American. This fact is relevant because Pac 21 is qualified in some jurisdictions as a Minority Business Enterprise ("MBE"). Such businesses are often afforded preferential treatment in contract bidding, pricing, awards and other areas. It is important that Dismo keep in mind that such preferential treatment is not only common with respect to certain governmental entities but is often used by private corporations as part of their community relations program. Accordingly, Dismo's financial and industrial due diligence team will have to exercise caution to determine what portion of Pac 21's historical business, as well as its projected business, is tied to its MBE status. It is likely that, after an acquisition by Dismo, Pac 21 would no longer enjoy MBE status. D. Shareholders. The current shareholders and shareholdings are, according to the records of the company, as follows (alleged MBE shareholders are identified with an asterisk): John YaYa 6,900 shares (46%)John Smallberries* 1,950 shares (13%) John BigBoot* 1,950 shares (13%)John Bonzai 1,950 shares (13%) Joe Smith 750 shares (5%) Tom Black 750 shares (5%)Kevin Eagle* 750 shares (5%) * According to John Smallberries, each of these individuals is of Native American ethnicity, and therefore provides the basis for MBE treatment. Dismo should note that the transfer ledger relating to the issuance of shares, the cancellation of shares, and various other transactions involving Pac 21 shares, is incomplete in many respects. It is imperative that prior to closing Pac 21 correct any historical aberrations in its stock transfer records, locate lost stock certificates (or secure affidavits of lost stock certificate) and perhaps secure estoppels or waivers by any individuals who appear in the stock ownership record, but are not currently believed to be shareholders of Pac 21. This is an area of particular concern since it goes to the heart of the ownership make-up of the company. None of the share certificates contains legends relating to the restricted nature of the stock. Accordingly, the pre-closing documents, in addition to the legends relating to each shareholder's agreement which appear on the reverse of certain stock certificates, Pac 21 should include other required language relating to transferability and lack of registration under the Securities Act of 1933. E. By-laws. As with other aspects of the Pac 21 corporate records, the state of the company's by-laws is uncertain. For example, the by-laws currently contained in the record books are the historical by-laws of the company going back some time. However, in other files, we found records which reference another set of by-laws reflecting changes requested by various jurisdictions in connection with MBE status of Pac 21. It is unclear whether the new by-laws were ever adopted. Pac 21 must eliminate all uncertainties concerning its by-laws prior to closing of any acquisition by Dismo, and the by-laws to be in force at closing must be satisfactory to Dismo. F. Shareholders' Agreements. Each of the current shareholders of Pac 21 is a party to a shareholder's agreement. Among other things, the shareholders' agreements contain various restrictions on sale and transferability. Of special interest is section 7 of each agreement: "Majority Go Along," which provides that if a simple majority-in-interest of Pac 21 shareholders approves a sale of Pac 21's shares to an independent third party for arm's length consideration, each of the other shareholders is required to transfer his shares for the same pro-rata consideration. Subject to Massachusetts law, it is likely that this provision will facilitate dealing with any shareholders who may wish to dissent from the proposed transaction. Obviously, we will require an opinion of Pac 21's Massachusetts counsel as to the propriety of all corporate actions taken by Pac 21 in connection with the proposed transaction, including any reliance upon the provisions of section 7 of the shareholders' agreements. In addition, the shareholders' agreements should be terminated simultaneously with closing and replaced with Dismo shareholders' agreements relating to ownership of Dismo Shares. G. Employment Agreements. Each of the senior executives of Pac 21 has executed an employment agreement. Even though these employment agreements appear to be generally acceptable from a legal perspective, we recommend that each agreement be terminated at closing and that new employment agreements in the standard Dismo form be entered into with all Pac 21 executives who will remain with the new company. H. Employee Benefits. In addition to the usual customary employee benefits, Pac 21 maintains a 401(K) plan. Because 401(K)s are closely monitored and regulated vehicles, and given the recent vigorous audits of 401(K) plans by the IRS and DOL, it is imperative that Dismo's benefits manager or retained consultants carefully review the terms of any applicable 401(K) plan to be transferrred to our client and confirm that not only is its structure in compliance with applicable law, but that all contributions to the plan have been made timely and in other respects in accordance with applicable law. In addition, we would want to review investment options and their applicability to date to determine the fiscal soundness of the plan. Please advise whether Dismo will handle this in-house or whether you would like our employee benefits group to conduct further due diligence in that regard. I. Litigation and Disputes. Pac 21 is party to at least one pending lawsuit in Utah and an additional dispute which appears to have been submitted to arbitration in New York. Although we do not, at present, have enough information to assess the risk profile of each of these proceedings, it is clear that the matter relating to pending arbitration has the potential to be problematic and, in a bad-case scenario, to have a materially negative effect on Pac 21 and its financial performance. That matter relates to alleged breaches by Pac 21 of certain non-competition and other provisions of an extremely complicated "Agreement for Settlement of Accounts" dated November 1999. The opposing party to that proceeding is B&O, who is the current owner of Master Work (the former parent company of Pac 21). The facts, circumstances and history surrounding that transaction are extraordinarily convoluted, and as a result suggest that substantial further due diligence will be required. In addition, in the context of the arbitration, B&O has made clear that it intends to seek specific performance and monetary damages. Both the legal and operational teams should be given substantial additional opportunities to explore both the Utah and the B&O disputes. Obviously, our first preference would be that each of these matters be settled and that related releases be executed prior to closing. J. XYZ Acquisition. In 1999 Pac 21 acquired a Florida LLC referred to as "XYZ." Both the operational and accounting due diligence teams will need to review that transaction. In particular, we need to understand clearly what historical liabilities may have been assumed, confirm compliance with accounting, tax, and other financial requirements, and otherwise assess the possible risks associated with that acquisition. In addition, in connection with that acquisition, three new shareholders--Kevin Eagle, Tom Black, and Joe Smith--acquired their ownership interests in Pac 21. We have been advised that pursuant to the terms of those agreements, each of the former XYZ shareholders has an option which will enable him to acquire additional shares of Pac 21, thereby increasing the collective ownership of these three shareholders to over 30%. Obviously, we need to understand very clearly the workings of those arrangements and address them in the context of any potential acquisition by Dismo. K. Miscellaneous Matters. During the meetings in Pac 21's offices, it was evident that a number of boxes and other items were being packed up, and we were advised that Pac 21 was vacating its current leasehold premises and has rented additional space elsewhere. We should confirm that Pac 21 is leaving its lease arrangement voluntarily and not as a result of a breach. In addition, we should be given an opportunity to review the specific terms of any new lease agreement to develop a clearer understanding of what financial obligations may be payable in the future by Dismo as part of the overall purchase. With respect to related party contracts, it is not uncommon for small companies like Pac 21 to have a number of transactions with its principal shareholders. Indeed, in the case of Pac 21, our review uncovered a number of related party relationships with John YaYa. Most of these involve promissory notes or other monetary or economic exchanges. The accounting and tax due diligence teams from Arthur Ernst need to determine the propriety of those transactions, and we will need to review them as well from a corporate legal compliance perspective. In addition, we were advised by John Smallberries that certain promissory notes issued to John YaYa in connection with the XYZ acquisition are currently being paid by Pac 21 (the obligors on the original notes which we reviewed in Pac 21's offices were the former XYZ shareholders). We need to have a much better understanding of exactly how these obligations were transferred to Pac 21, the tax and legal implications thereof, and the appropriateness of Pac 21 continuing to make such payments in the future. Finally, we would suggest that background checks be run on each of the principals of Pac 21. We understand that this is now standard procedure for Mondo Dismo portfolio companies, and would encourage Dismo to coordinate any such background check through Mondo's usual provider. Schedule I Officers and Directors of Pac 21 John YaYa Chief Executive OfficerJohn BigBoot Chief Financial Officer John Smallberries General Counsel and Vice President for Law John Bonzai Corporate Secretary Joe Smith Co-Director Tom Black Assistant General CounselKevin Eagle Managing Director Schedule IIArthur Ernst, L.P Independent AuditorSuzi Que Mary Money Todd Wright Slaker and Scoobey Retained Legal Counsel James Slaker Robert Luser Joe Blough Risky Business Retained Risk Manager Tim Stakes Jeff Brown