Target is a manufacturer based in Kentucky with customers worldwide. In July 2016, Buyer purchased Target from Sellers for approximately $87 million. Sellers sold Target to Buyer through a stock purchase agreement dated July 11, 2016.
Some Target employees worked in foreign countries including, China. The stock purchase agreement included a representation that Target’s benefit plans for its foreign employees complied with all applicable legal requirements in all material respects. The stock purchase agreement also included a representation that Target’s financial statements from January 2014 through April 2016 were accurate in all material respects.
The stock purchase agreement provided that Sellers would indemnify Buyer for losses that exceed $250,000 arising from a breach of any warranty or from an inaccurate representation in the stock purchase agreement.
After the closing, Buyer discovered a problem with one subsidiary of Target, Target China Subsidiary. Target China Subsidiary employed workers in China and, as a result, was required by Chinese law to make pension and insurance contributions, pay bonuses, and give its employees leave (collectively, “social insurance payments”). The amount of these contributions varied by province and was calculated based on each employee’s base salary.
Specifically, Buyer discovered that Target China Subsidiary paid $563K less to the Chinese government than it was required to do, by allowing its employees to report inaccurate base salaries. Buyer had calculated the purchase price it paid for Target based on Target’s financial statements. Buyer concluded that the underpayment of Chinese taxes caused Buyer to pay $7.7 million more than it would have if Target’s financial statements had been accurate.
In addition, when Buyer discovered the underpayments, Buyer revised Target China Subsidiary’s internal policies to comply with Chinese law, which required the devotion of internal resources away from regular course tasks as well as payments to outside legal counsel. Nevertheless, Buyer did not claim that any province in China had acted to seek payment of back taxes.
Buyer sued Sellers in a New York federal district court on July 10, 2018. Buyer claimed that Sellers breached the stock purchase agreement by misrepresenting Target’s compliance with Chinese law governing social insurance payments and by failing to include additional costs associated with that compliance in Target’s financial statements.
Sellers moved to dismiss this claim. The court ruled for Buyer, meaning that Buyer’s breach of contract claim could proceed.
In ruling for Buyer, the court noted that Buyer had claimed that the purchase price for Target would have been lower had Buyer known of Target’s noncompliance with Chinese law, and that Buyer spent money to remedy Target’s noncompliance.
Those Buyer allegations if true could establish a breach by Sellers of the stock purchase agreement. Sellers represented in the stock purchase agreement that Target’s financial statements were materially accurate, and that Target’s foreign employee compensation and benefits complied with foreign law. Buyer’s allegations that both representations were false state a claim for breach of the stock purchase agreement.
The court also rejected Sellers argument that no breach of contract claim by Buyer was stated because Buyer did not allege that the Chinese government has required any back payments from Target. The court held that inaction by the Chinese government as well as Buyer’s purported opportunity to conduct due diligence before closing will have to be assessed at a later stage of this litigation.
This case is referred to Danfoss Power Solutions (US) Company v. Maddux, No. 18cv6237 (DLC), United States District Court, S.D. New York, (December 6, 2018).
Comment. Reps and warranties of a seller seem like boilerplate. But they can be very important to a buyer in getting the benefit of the deal when unknown pre-closing liabilities rear their ugly head after the closing.
By John McCauley: I help people start, grow, buy and sell their businesses.
Telephone: 714 273-6291
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