Court Greenlights Business Asset Buyer’s Fraudulent Inducement Claim Re 2-Year Noncompete Term

Introduction

Sometimes being a good guy in an M&A deal can come back to bite you. If the buyer’s allegations are true, then this feels like a no good deed goes unpunished story.

The deal

Here, both the buyer and seller were in the customer printing business. The seller’s founder and owner told the buyer that he wanted “to exit the custom folder printing business forever because they saw no future in the business”.

The buyer purchased the business from the seller for approximately $15 million. The deal was done through an asset purchase agreement.

The seller’s owner and seller gave the buyer a 2 year noncompetition covenant; short but the buyer felt ok given that the seller and its owner were getting out of the custom printing business.  Also, the buyer leased the seller’s customer printing facility for 2 years from an LLC owned by the Seller’s owner.

The lawsuit

Things went well for about 21 months. Then the seller’s owner told the buyer that it was not going to renew the 2 year lease and that the buyer was going to have to vacate the premise.

The buyer vacated the premises. After that the seller’s owner relaunched a custom printing business out of his old facility; and it was after the expiration of the two year noncompetition covenant term.

The buyer sued the seller and its owner in an Omaha federal district court. One of its claims was for fraudulent inducement. The buyer claimed that it agreed to a short 2 year noncompetition term because the seller’s owner had said that he was getting out of the customer printing business forever.

The buyer claimed that it would never have paid $15 million for the business with a 2 year noncompetition covenant had it known that the seller’s owner’s true intent was to pay off his crushing debt with the $15 million purchase price and then relaunch the business after the 2 year noncompetition covenant term expired.

The court agreed with the buyer: “The Court concludes that … (the buyer) … has stated a claim for fraudulent inducement. Assuming … (the buyer’s) … allegations are true, the operative complaint contends that … (seller and its owner) … committed fraud by ‘falsely representing that they desired to exit the custom folder printing business forever because they saw no future in the business’ when … (their) … ‘true intent was to generate funds to pay down crushing debt… (they) … had accumulated and then to reenter the business in direct competition’ … Relying on … (their) … representation, … (the buyer) … agreed to a short, two-year restrictive covenant and paid… (the seller) … for its printing business. … As a result of that conduct, … (the buyer) … was damaged.”

This case is referred to as Crabar/GBF, Inc. v. Wright, No. 8:16-CV-537, United States District Court, D. Nebraska (August 26, 2019)  

Comment

With 20/20 hindsight, the buyer would want a four or five year noncompetition covenant term.

By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291

 Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in covenant not to compete, fraudulent inducement, noncompetition covenant term Tagged with:

Court Finds No De Facto Merger in Purchase of Bankrupt’s Intangibles-IP

Introduction

Buyers of manufacturing businesses must always assess product liability risks. Even when buying the assets of the business as opposed to the stock (or LLC membership interests).

The deal

Here, the manufacturing company in this case made lathes. It eventually filed for bankruptcy and its assets were sold to another company.

That company sold the manufacturer’s intangible assets (pricing and customer information as well as intellectual property such as know-how) to the buyer.

The buyer builds machines for a variety of industrial applications; and manufactures and services parts for machines made by other companies, including machines originally made by the manufacturer.

The lawsuit

The manufacturer had sold a lathe to a customer before the bankruptcy. An employee of the customer was injured when a piece of metal was released from a lathe manufactured and designed by the manufacturer.

The injured employee could not find the manufacturer and sued the buyer which ended up in an Oklahoma federal district court; claiming that the buyer was a successor to the manufacturer under Ohio’s de facto merger successor liability doctrine.

The plaintiff argued that it had acquired not only the manufacturer’s intangible assets (including its intellectual property) but also on its website held itself out to be the manufacture using such words as “we are” the manufacturer and “as” the manufacturer. The buyer responded that it made such assertions for many legacy companies, not just the manufacturer; but that it does not claim actual ownership of these legacy companies.

The court rejected the de facto merger claim, because the buyer did not buy the manufacturer’s “brick and mortar office, as well as its inventory.”

This case is referred to as Sowell v. Bourn & Koch, Inc., Case No. 18-CV-0320-CVE-FHM, United States District Court, N.D. Oklahoma (August 15, 2019)  

Comment

A de facto merger is a stretch in any case where there is no common ownership between the seller and the buyer. And even the product line exception to the successor liability doctrine requires that the buyer acquire substantially all of the seller’s assets; which apparently did not happen in this case.

By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291

 Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in asset purchase agreement, de facto merger exception, successor liability Tagged with: , ,

Court Says Treadmill Maker Asset Buyer Assumed Implied Merchantability Warranty

Introduction

One legal risk in buying a manufacturing business is product liability. Purchasing the assets as opposed to the equity of the manufacturer reduces that risk. However, in all states the buyer may be responsible for any product liability claims that it expressly assumes in the asset purchase agreement.

The deal

Here, the buyer purchased the assets of a company that made treadmills. In the APA the buyer assumed only the seller’s repair or replace warranty and expressly stated that the buyer was not assuming any other seller product liability.

The lawsuit

Before the closing the seller sold a treadmill to a gym that a woman later visited. One day while using the treadmill, she fell, striking her head. She later died due to her injuries from the fall.

The family sued the buyer in a Texas state court, claiming that the buyer had assumed Wisconsin’s UCC version of the implied warranty of merchantability. The buyer claimed it did not.

The trial court agreed with the buyer and the family appealed to a Texas intermediate appellate court. The appellate court reversed finding that the seller warranty did not expressly exclude the implied warranty of merchantability within the meaning of the UCC.

This case is referred to as Kouba v. Northland Industries, Inc., No. 01-18-00252-CV, Court of Appeals of Texas, First District, Houston (Opinion issued August 13, 2019)  

Comment

The buyer had a good argument that it did not assume the seller’s implied warranty of merchantability. It seemed clear that the seller had an implied warranty of merchantability; but it was also clear under the APA that the buyer was only assuming seller’s repair or replace warranty. In fact, the chief justice of this Court of Appeals of Texas, First District, Houston filed a strong dissent, which agreed with the buyer’s position.

The takeaway: a buyer of the assets of a manufacturer should expressly disclaim any assumption of any seller implied warranty of merchantability in its APA.

By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291

 Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in assumed liabilities, implied warranty of merchantability, seller's warranty claims Tagged with:

7th Circuit Upholds 25% CERCLA Allocation to Innocent Business Buyer

Introduction

Buying a business with CERCLA issues is fraught with risk. The buyer hopes that it can price the deal correctly; which includes an estimate of what if anything the buyer can recover from the actual polluter.

The deal

Here, the buyer purchased an environmentally contaminated Indiana steel mill out of bankruptcy in 20014. The mill was offered for sale at $20 million and sold for $6.4 million.

The lawsuit

The buyer sued the former owner who had caused the contamination to recover its cleanup costs under CERCLA in an Indiana federal district court. The court ordered the former owner to pay 75% of the costs leaving the buyer responsible for the remaining 25%. The buyer appealed.

The buyer argued that the former owner should be responsible under CERCLA for 100% of the cleanup costs as it caused the pollution. The 7th Circuit Court of Appeals disagreed. It said that CERCLA gives courts the authority to allocate the cleanup costs between the former owner and the buyer based upon what is fair and rationale.

Here, the buyer knew going into the deal of the extensive cleanup issues. Furthermore, it had purchased the steel mill at a deep discount. Thus, it was fair and rationale to stick the buyer with 25% of the cleanup costs.

This case is referred to as Valbruna Slater Steel Corporation v. Joslyn Manufacturing Company, Nos. 18-2633, 18-2738, United States Court of Appeals, Seventh Circuit (Decided August 8, 2019)  

Comment

A lesson for a buyer of businesses with environmental problems is to not expect that only deep pocket former owners who were at fault will ultimately bear all the clean up costs; especially if the buyer knew about the problem and used that information to get a significant price reduction.

By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291

 Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in CERCLA or superfund liability, successor liability Tagged with:

9th Circuit Holds APA’s Delaware Forum Selection Clause Contravened Strong Idaho Public Policy

Introduction

Many buyers and sellers in M&A transactions like Delaware courts to handle their disputes because of the reputation for competence. Thus, it is common to see a Delaware forum selection clause in M&A agreements.

Some parties to a deal will challenge the forum selection clause in a post-closing dispute; sometimes successfully. The seller in this deal unsuccessfully challenged such a clause in an Idaho federal district court. See my earlier blog on this talking about the trial court’s decision: Importance of boilerplate provisions in business purchase agreement – forum selection clause; http://www.mk-law.com/wpblog/importance-of-boilerplate-provisions-in-business-purchase-agreement-forum-selection-clause/

That seller recently got the 9th Circuit to reverse and refuse to enforce the APA’s Delaware forum selection clause.

The deal

Here, the buyer purchased the assets of an Idaho business for cash and an earn out. The APA had a Delaware forum selection clause.

The lawsuit

The seller sued the buyer in an Idaho federal district court to recover amounts claimed owed under the APA. The buyer asked the court to dismiss the action because of the APA’s Delaware forum-selection clause under the forum non conveniens doctrine; which would force the seller to sue the buyer in Delaware.

The seller resisted the buyer’s request arguing that the APA’s Delaware forum selection clause is unenforceable because it contravenes the state of Idaho’s strong public policy expressed by the Idaho legislature. The Idaho law expressly declares that a provision like the APA’s Delaware forum selection clause “is void as it is against the public policy of Idaho.”

The trial court rejected the seller’s argument and the seller appealed to the 9th Circuit. The appellate court held that the APA’s Delaware forum selection clause was unenforceable and reversed. Applying the federal forum non conveniens doctrine, the court concluded that the APA’s Delaware forum selection clause contravened the strong public policy of Idaho as expressed in the Idaho statue.

This case is referred to as Gemini Technologies, Inc. v. Smith & Wesson Corp., No. 18-35510, United States Court of Appeals, Ninth Circuit (Filed: July 24, 2019)

Comment

The court in this 9th circuit decision said that its decision is in line with the recent decisions of other federal circuits (D.C., 2nd, 3rd, and 5th).

How many other states have laws like Idaho? This court said four (Montana, North Dakota, Oklahoma, and North Carolina).

By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in contravene strong state public policy, forum non conveniens doctrine, forum selection clause Tagged with: , ,

Business Buyer’s APA Offset Rights Fund Its Environmental Legal Defense Costs

Introduction

A buyer of a business likes offset rights. An offset right provision in a M&A purchase agreement gives the buyer the right to offset losses that it suffers that are the seller’s responsibility from post-closing payments that the buyer otherwise owes the seller. In this case the buyer got more of an offset right than usual.

The deal

Here, the buyer purchased all the assets of a Los Angeles-based chrome plating business, except for the real property on which the business was situated. The purchase price included a $3 million note with quarterly interest payments with payoff in 5 years.

At the time they entered into the APA, the parties were aware that Seller’s chrome plating facility was environmentally contaminated. The agreement provided for reciprocal indemnification for this risk depending up whether “release or threatened release of a hazardous substance” occurred before or after the closing.

The lawsuit

The environmental risk materialized when the seller was sued in California after the closing. The seller then brought the buyer into the California lawsuit claiming indemnification for any loss it suffers arising out of any post-closing environmental contamination.

The buyer retained counsel and incurred attorneys’ fees and consultant costs associated with the California litigation. While the buyer and seller continued to litigate their respective clean-up obligations in California, the buyer notified the seller that the buyer intended to exercise its right to offset those attorneys’ fees against the next quarterly interest payment due under the note.

The seller challenged the buyer’s right to offset in the Delaware Superior Court. The seller based its challenge on the APA offset provision. It argued that the buyer could only offset fees incurred in connection with pre-closing environmental contamination; and at this stage of the California litigation it had not been established whether these legal fees were incurred in connection with pre-closing or post-closing contamination.

The buyer said it did not matter that the legal costs may ultimately relate to post-closing contamination. It only mattered that the legal costs related to environmental contamination on the seller’s property.

The court agreed with the buyer; saying the agreement gave the right of the buyer to offset its legal costs connected with the California environmental litigation, regardless of whether ultimately, the buyer would be held responsible for those costs as post-closing contamination.

This case is referred to V&M Aerospace LLC v. V&M Company, C.A. No. N18C-09-189 AML CCLD, Superior Court of Delaware (Decided: July 18, 2019)

Comment

20/20 hindsight tells us that drafting would have solved seller’s problem. The first sentence of the offset provision gives the buyer the right to offset for all losses other than losses relating to environmental claims that are “subject to indemnification.” The second sentence gives the buyer the right to offset losses related to environmental claim; but does not limit those to indemnifiable environmental claims; meaning pre-closing contamination claims.

Why were there two sentences? Because the environmental offset right in the 2nd sentence expanded buyer’s offset rights from not only note and lease payments, but to consulting payments.  So, it had to be there. The fix for the seller would be to have the “subject to indemnification” limitation apply in the 2nd sentence to environmental claims as it did in the first sentence.

By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in environmental, indemnification, offset or setoff provision Tagged with: , , ,

Tolling of SPA Survival Period Didn’t Extend Delaware’s Statute of Limitations Period

Introduction

It is common in M&A agreements to specify survival periods for making indemnification claims; and to toll the survival period while a timely indemnification claim is pending. However, although a survival period under Delaware law can shorten the applicable statute of limitation; it cannot extend the applicable statute of limitations for contract claims; at least not before the enactment of a 2014 Delaware law.

The deal

Here, the target designed and manufactured oil analyzers, which it sold and shipped to customers, primarily for on-premise coolant, oil, and lubrication testing for municipal and commercial fleet vehicles. The buyer purchased the stock of the target from the seller pursuant to a stock purchase agreement.

The seller’s obligations under the SPA were secured by $500K which was deposited by the buyer into an escrow account. The escrow agreement further provided that the balance of any escrowed funds not subject to an indemnification claim—whether pending or disputed—would be released within three business days of the first anniversary of the closing.

The lawsuit

Before the stock purchase closed, the target had shipped approximately 640 analyzers containing unlicensed software owned by Microsoft. Neither the target nor the seller disclosed these facts to the buyer prior to the closing. To the contrary, the target and the seller represented and warranted in the stock purchase agreement that the target was authorized to use the software, had obtained all necessary licenses, and was in compliance with all laws.

The buyer discovered the issue and investigated its scope after the stock purchase closed. The buyer determined that of the 640 shipped analyzers containing unlicensed software, approximately 330 (the “legacy units”) remained in worldwide use after the closing.

Several weeks before the 1st anniversary of the closing, the buyer sent a letter to the seller and the escrow agent claiming indemnification under the stock purchase agreement. The claim notice cited the target’s “failure to procure and maintain appropriate software licenses” for its analyzers as the basis for the buyer’s claim. The seller responded 2 days later with a letter disputing the buyer’s indemnification claims.

The buyer entered into a settlement with Microsoft six months later. In exchange for a payment, Microsoft released both the buyer and the target from claims relating to the unlicensed software used in the legacy units. Microsoft, however, did not release the end users of the 330 legacy units. This left the target exposed to licensing related claims by the end users of the legacy units, particularly those end users who Microsoft may contact or sue.

The buyer immediately notified the seller of the buyer’s settlement with Microsoft. The buyer demanded that the seller immediately authorize the escrow agent to pay from the escrowed funds the amount of the settlement consideration, plus attorneys’ fees and costs. The buyer also reserved its right to seek indemnification against the balance of the escrowed funds for future losses.

The seller did not authorize a release of escrowed funds and the dispute ended up in the Delaware Court of Chancery. One of the issues was whether the buyer’s indemnification claim against the seller for breach of the seller’s SPA intellectual property representation and warranty claim was barred by Delaware’s 3 year statute of limitations for contract claims.

The court said yes. The statute of limitations barred the claim even though the one year survival period was tolled by the pending indemnification claim. The seller’s breach of the IP rep and warranty occurred on the date of the November 2014 closing and so Delaware’s 3 year statute of limitations for contract claims expired in November of 2017; 8 months before the buyer sued the seller on this claim.

The buyer conceded that the SPA survival period for breach of the seller IP rep and warranty was 1 year. However, the buyer argued that the SPA the one year survival period and the 3 year statute of limitation period were tolled when the buyer made its indemnification claim within 1 year of the closing; a claim which was still pending when the buyer sued the seller over three years after the closing.  The court agreed that the pending indemnification claim tolled the one year survival period under the SPA. However, the indemnification claim did not toll the 3 year statute of limitations. Therefore, the IP representation and warranty breach claim was barred because the buyer failed to sue the seller by the 3rd anniversary of the closing.

This case is referred to Kilcullen v. Spectro Scientific, Inc., C.A. No. 2018-0429-KSJM, Court of Chancery of Delaware (Decided: July 15, 2019)

Comment

The case goes on because of other legal claims.

A 2014 Delaware law now permits buyers to extend by contract the Delaware 3 year statute of limitations for contract claims for up to 20 years. See 10 Del. Code § 8106(c) and Bear Stearns Mortgage Funding Trust v. EMC Mortgage LLC, C.A. No. 7701-VCL, Court of Chancery of Delaware, (Decided: January 12, 2015).

So, going forward, a buyer could specify in a M&A agreement subject to Delaware law, a survival period and statute of limitation up to 20 years.

By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291

 Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in extension by contract in Delaware, indemnification, statute of limitations, survival of reps and warranties, tolling Tagged with: , ,

Business Asset Buyer Wins Successor Liability Skirmish with Union

Introduction

This is a continuing saga of a business asset buyer’s post-closing battle with a seller’s union. Chapter 1 is found in an earlier blog: http://www.mk-law.com/wpblog/court-says-asset-buyer-of-business-can-sue-seller-for-failure-to-disclose-its-union-contract-obligation/

The deal

The seller and buyer both performed waterproofing, concrete and masonry restoration, and roofing services in Nebraska and the Midwest. In November 2014, the seller sold its assets to the buyer.

The buyer claims that it was told by seller’s owner that the seller did not have a union agreement. Furthermore, the buyer said that it did not assume any union liability in the asset purchase agreement.

The lawsuit

After the closing, seller’s union sued the buyer in a Kansas federal district court as a successor to seller, to recover seller’s unpaid union contributions. At this point the seller had a bank account balance of $427.90, having received a cash payment of $1.9 million from the asset sale, which the buyer asserts were distributed to the seller’s owner’s personal account. The buyer continues to make asset sale payments of $6,351.75 per month (which continue through 2021), and lease payments of $3,800 per month.

The union sued the buyer on several theories and asked the court to rule as a matter of law that the buyer was responsible for the seller’s unpaid union contributions. First, the union claimed that the buyer was responsible as a successor to the seller under federal common law. Here the principal issue was whether the buyer knew about the union contract. And on this theory, the court said that it was a question of fact to be decided by the jury in that buyer claimed that the seller assured the buyer that there was no seller union liability.

Second, the union claimed that the buyer manifested an intent to be bound to the seller’s union contract. The buyer denied most of the union factual allegations that supported this theory. The buyer did admit that it remitted contributions to the union during the first five months of its ownership. However, it said that it only withheld union dues to prevent employees from losing health insurance while it made decisions regarding employee health insurance. Also, on this theory, the court said that facts, not the law, will decide this claim, and that is a determination to be made later by a jury.

The battle continues.

This case is referred to BAC Local Union 15 Welfare Fund v. Williams Restoration Company, Civil Action No. 19-649-RGA-SRF, Civil Action No. 16-2242-KHV, United States District Court, D. Kansas (July 12, 2019)

Comment

The seller apparently denied that it had a union contract.  Perhaps due diligence could have uncovered seller payments to the union.  A lesson from this case for a buyer would be to focus some potential union liability due diligence on a target business that is in an industry that uses union labor.

By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in actual knowledge, constructive knowledge, successor liability, union liabilities Tagged with: , , ,

Trust but Verify-Business Seller Failed to Verify Accuracy of Earnout Statement

Introduction

A buyer and seller of a business often use an earnout when they can’t agree upon a purchase price. In that case, the purchase agreement provides for a buyer calculation of the earnout amount, along with an earnout dispute resolution procedure; which gives the seller the right to verify and challenge the accuracy of the earnout calculation.

In this case the seller did not verify or challenge the accuracy of buyer’s earnout calculation; and  lost the right to a potential earnout.

The deal

The Texas based seller was in a business that provided environmental management services to the oil and gas industry. Pursuant to an asset purchase agreement, or APA, the seller sold the business assets to the buyer in 2015 for a fixed purchase price plus an earnout based upon the earnings of the business for the calendar years ending 2016, 2017, and 2018.

The lawsuit

In accordance with the terms of the APA, the buyer delivered the 2016 and 2017 earnout statements to the seller. The 2016 and 2017 earnout statements represented that the business generated a loss and, consequently, no earnout payment was due in those years. The seller did not review the materials used in preparing the 2016 and 2017 earnout statements, nor did the seller challenge the accuracy of the 2016 and 2017 earnout statements within the thirty-day window for delivering an earnout dispute notice, in accordance with the APA.

After receiving more data related to the 2018 earnout statement, the seller began to suspect that there were material misrepresentations or miscalculations in the 2016 and 2017 earnout statements. The seller in November 2018 made a formal written request for the underlying documentation forming the basis of the 2016 and 2017 earnout statements, but the buyer declined to provide the documentation.

The seller sued the buyer and the dispute ended up in a Delaware federal district court.

The seller accused the buyer of manufacturing losses by diverting business earnings to other buyer companies and charging improper expenses to the business. However, the seller had to base its claims on fraud (a tort remedy) instead of relying upon the APA’s contract remedy because the seller had not followed the APA’s earnout dispute resolution procedures.

The buyer asked the court to dismiss the seller’s complaint because the seller had no right to sue the buyer for fraud. The U.S. magistrate agreed with the buyer and has recommended that the Delaware federal district court dismiss the seller’s lawsuit, with prejudice.

The magistrate held that the seller’s claim for fraud falls because the seller had the right under the APA to inspect the books and records of the business to verify the accuracy of buyer’s calculations; and if timely disputed, cause the earnings calculation to be made by an independent accounting firm; but the seller failed to do so.

This case is referred to Richie v. Hillstone Environmental Partners, LLC, Civil Action No. 19-649-RGA-SRF, United States District Court, D. Delaware, (July 9, 2019)

Comment

The magistrate also rejected the seller’s claim for fraud based upon the economic loss doctrine, which generally prohibits recovery against the buyer by a seller of a business in tort for economic harm. The purpose of the economic loss doctrine is to prevent tort law from reallocating risks between the buyer and the seller who fairly have negotiated an arms-length asset purchase agreement.

In the present case, the federal magistrate noted that the seller sought the recovery of monetary damages mirroring the relief permitted under the APA; which required the buyer to compensate the seller for any inaccuracies in the earnout statements in accordance with the determination by an independent accounting firm. Thus, the magistrate concluded that the economic loss doctrine also prevented the seller from suing for fraud.

The magistrate also rejected the buyer’s attempt to come within the fraud in the inducement exception to the economic loss doctrine because although fraudulent inducement is a recognized exception to the economic loss doctrine, the exception does not apply where, as here, the fraud claim relates to the buyer’s performance under the APA, as opposed to buyer committing fraud upon the seller to induce the seller to enter into the asset purchase agreement in the first place.

By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in earn out, earn out dispute procedure, economic loss doctrine, fraud in business sale, fraud in the inducement exception Tagged with: , , , , , ,

CA Court of Appeals Dissent Invites CA High Court to Clarify 363(f) Asset Sales with Alad Product Liability Claims

Introduction

A buyer of a manufacturer, distributor or retailer of products out of bankruptcy expects that it can acquire the business free and clear of product liability claims under section 363(f) of the bankruptcy code.

The deal

This case involved the purchase of the National Car Rental business out of bankruptcy in 2003.

The lawsuit

After the closing, the buyer was sued by a plaintiff who was a passenger in a 1992 Oldsmobile Cutlass that was involved in a head-on 2004 collision. She survived, but as a paraplegic.

The vehicle had been owned by GM’s car rental business, National Car Rental in 1992. The vehicle was sold by the GM company in 1993 to a private buyer as a used car.

The GM company sold the National Car Rental business to a company in 1995. That company filed for bankruptcy in 2001 and sold the National Car Rental business out of bankruptcy to the buyer.

The plaintiff claimed that the Oldsmobile was defective and sued the buyer as a successor to the bankrupt company. The plaintiff sued the buyer in a California trial court, claiming that the buyer was responsible for this product liability claim because it expressly assumed the liability in the 2003 asset purchase agreement, and also under California’s product line exception first developed by the California Supreme Court in the 1977 decision of Alad.

The buyer filed a motion for summary judgment arguing that it did not assume any product liability for this vehicle because the buyer never purchased the vehicle nor assumed any liability associated with this vehicle. The trial court and the intermediate appellate court majority agreed with the buyer.

The buyer also argued that it had no liability under Alad because its seller’s voluntary bankruptcy destroyed the plaintiff’s remedies not the buyer’s acquisition of the business. The California Court of Appeals majority also agreed with the buyer.

This case is referred to Hernandez v. Enterprise Rent-A-Car Company, No. A152703, Court of Appeals of California, First District, Division Four, (Filed July 8, 2019)

Comment 

This case is probably not over. Justice Jon B. Streeter of the California Court of Appeals (the former president of the State Bar of California) filed a dissent challenging the majority’s two conclusions.

First, the dissent said that it is a reasonable interpretation of the asset purchase agreement that the buyer assumed responsibility for National Car Rental’s unknown product liability. That is because the buyer did not purchase only specific vehicles; it purchased the National Car Rental business, including the goodwill and the National Car Rental trade name. And the buyer did not identify unknown product liability claims in the asset purchase agreement as excluded liabilities.

Second, the dissent argued that buyer may be responsible for plaintiff’s product liability claim under Alad because bankruptcy may have not destroyed plaintiff’s remedy against the seller. The dissent cited the 2016 federal 2nd circuit decision of Elliot, for the proposition that an asset sale out of bankruptcy may not eliminate successor liability arising from unknown claims at the time of sale.

The dissent invited review by the California Supreme Court: “Both are close questions that have arisen persistently over the years but that have not been definitively resolved. They both are deserving of the California Supreme Court’s attention, if not in this case in some future case.”

By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

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Posted in 363(f)(3) sale, bankruptcy sale, distressed business acquisitions, product line exception, sale of product line, successor liability Tagged with: , , , ,

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