Nondisclosure Covenant May Protect Purchased Customer Info Even if Not Trade Secret

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March 31, 2020

Introduction

A buyer of a business does not want the seller or its owner to compete against it after the closing. One tool to manage this risk is the have the seller (and owner) provide a covenant in the acquisition documents to not disclose or use the business proprietary information, including customer information.

The deal

The buyer in this deal was a global seafood wholesaler and importer. Seller supplied sustainable artisan seafood to restaurants and markets out of San Francisco. The seller’s cofounder stayed on with the business after the closing as a key employee. This lasted for about a year when the seller cofounder left and started competing with his old business.

The lawsuit

The buyer’s revenue significantly dropped, and the buyer sued the seller cofounder in a California federal district court for misappropriating trade secrets, specifically customer information, and breaching a covenant in the acquisition documents not to use or disclose the customer lists.

The seller cofounder asked the court to dismiss the buyer’s claim for misappropriation of trade secrets, arguing that the buyer in its complaint had not said how the customer information was a trade secret, as opposed to being known to the buyer’s seafood distribution industry competitors. The court agreed with the seller cofounder but gave the buyer permission to amend the complaint to allege how the customer information was a trade secret.

Nevertheless, the court did say that the buyer could pursue its claim against the seller founder for breach of his confidentiality covenant to not use or disclose the customer information; saying that the seller cofounder’s written promise in the acquisition documents to not use or disclose the customer information is enforceable even if the customer information  is not a trade secret.

This case is referred to as CleanFish, LLC v. Sims, LLC,, Case No. 19-cv-03663-HSG, United States District Court, N.D. California (March 17, 2020).  

https://scholar.google.com/scholar_case?case=8315568410757728291&q=%22asset+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2017

Comment

A buyer can use several tools to keep the seller and seller owners from competing against the buyer after the closing. One is to have the seller and its owners execute a reasonable covenant not to compete.

Also, the buyer should protect the purchased customer information and other proprietary information. However, the buyer should not rely solely upon federal and state trade secret laws to protect the customer information, because a buyer (like the buyer in this case) could be hard pressed to prove to a court that its customer information is a trade secret. The buyer should also make the seller and seller owners promise to not disclose or use the customer information in a confidentiality covenant as part of the acquisition documents.

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 customer list, customer list, nondisclosure agreement, trade secret misappropriation Tagged with: ,

APA Setoff Provision Applies Only to Liquidated Indemnification Claims

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March 19, 2020

Introduction

A buyer of a business often discovers problems with the business after the closing. And this risk is often covered by seller indemnification obligations.

In some cases, the purchase price was paid at the closing and the buyer is left with seller’s promise to indemnify the buyer for buyer’s loss. But often a significant portion of the purchase price has been deferred for payment after the closing.

Can the buyer, in such a case, refuse to make a post-closing seller payment until the indemnification issues are settled? Or at least reduce the amount of the payment by the cost of fixing the problem?

The answer depends upon the language in the purchase agreement.

The deal

This deal involved the purchase of the assets of an online business. The transaction was evidenced by a comprehensive asset purchase agreement that included seller representations and warranties about the business. A significant portion of the purchase price was paid after the closing.

The lawsuit

The buyer discovered problems with the business after the closing and stopped making purchase price payments; claiming that the seller had significant indemnification liability for the problems.

The dispute ended up in a Louisiana state trial court. There the key issue boiled down to whether the buyer had the right to withhold purchase price payments. Buyer said it did and pointed to a setoff provision in the APA which said that the buyer could “set off or recoup any indemnification payments owed to it by Seller …”

The seller argued that the buyer’s claims were unliquidated and not “owed” and thus the buyer was not entitled to setoff “unliquidated” claims against post-closing purchase price payments. The trial court agreed with the seller and the decision was affirmed on appeal by a state intermediate appellate court.

This case is referred to as Admin-Media, LLC v. AC OF Lafayette, LLC,, No. 19-691, Court of Appeal of Louisiana, Third Circuit (March 11, 2020).  

Comment

Not surprised with the outcome. Probably better outcome if the setoff language gave the buyer the right to set off indemnification claims against post-closing seller payments, as determined in good faith by the buyer, using commercially reasonable discretion.

However, the seller might pushback when negotiating the setoff language, by asking for the right to challenge the determination and resolve the dispute by arbitration.

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 offset or setoff provision Tagged with: ,

Seller Can’t Use LOI to Stop Buyer from Soliciting its Employees

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March 12, 2020

Introduction

Buyers and privately held sellers generally use letters of intent in business acquisitions. They primarily serve as a statement of the key business terms of the deal and are nonbinding. They also usually contain binding terms such as when and how to terminate negotiations, confidentiality, and the hiring and firing of seller employees.

Unfortunately, buyers and sellers sometimes don’t appreciate the legal risks involved in using LOIs. As a result, they often draft and sign LOIs without legal help. And this can lead to litigation if the deal does not close.

The deal

This deal involved competitors in the mortgage lending business. In this case the parties went through 5 drafts of an LOI that was never signed. The main sticking point was the buyer’s refusal to agree to not solicit seller’s employees. Buyer’s legal counsel drafted the drafts and seller’s CEO (a nonlawyer) negotiated and proposed modified language which included a no solicitation of seller employee clause.

The lawsuit

The deal never happened. The seller sued the buyer in a Minnesota federal district court. It accused the seller of soliciting its employees in violation of the LOI and asked the court to issue a preliminary injunction against the buyer ordering it to not solicit seller’s employees pending the resolution of the litigation.

The court said that it would not issue a preliminary injunction because the seller was not likely to win the lawsuit. Specifically, the court said that the buyer had no obligation to not solicit seller employees because no LOI was signed by the parties.

The only version of the LOI signed by the seller was a version prepared by buyer. Seller took this LOI draft; added the no seller employee solicitation provision; and signed it. The court said that the seller’s modification of the buyer draft LOI and seller’s signature of the modified LOI amounted to a seller rejection of the buyer version of the LOI and a counteroffer by the seller of the buyer drafted LOI with seller’s modification. However, the buyer never signed this modified LOI and thus never accepted this counteroffer.

Furthermore, the LOI had the usual breakdown of binding and nonbinding provisions, and the seller’s proposed non solicitation of employee language was not part of the binding provisions section of the LOI.

This case is referred to as American Mortgage & Equity Consultants, Inc. v. Everett Financial, Inc., No. 20-cv-426 (ECT/KMM), United States District Court, D. Minnesota (February 28, 2020).  

Comment

The seller would have been better served getting a lawyer involved to make sure that the non-solicitation provision was including as a binding provision; and that the buyer and seller sign the desired version of the LOI.

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 letter of intent, modification as counteroffer, no solicitation of seller employees, nonbinding Tagged with: ,

Bankruptcy Court’s 363 Sale Order Binds Buyer Who Then Declined to Sign APA

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March 11, 2020

Introduction

There can be many advantages to buying a distressed business in a 363 bankruptcy sale, including purchasing the business assets free and clear of seller’s liabilities. However, a 363 purchase has some unique features: including the required approval of the sale by a bankruptcy court sales order.

Outside of bankruptcy, usually, unless there is an unusual letter of intent, a buyer can negotiate aggressively with the seller and walk away from the deal if the parties cannot agree to purchase agreement terms. However, freedom to walk may be more difficult when buying a business out of bankruptcy.

The deal

This case involved a section 363 bankruptcy sale of a Washington D.C. area restaurant. A key asset was the lease. The buyer planned to remodel the restaurant which would take 6 months. The lease would put the tenant in default if the restaurant was closed for more than 3 months.

The buyer pushed the bankruptcy court to issue a sales order to modify the lease to change the 3 month restaurant closure provision to 6 months. The court agreed and issued the sales order approving the deal.

Nevertheless, the buyer got uncomfortable with the landlord’s attitude and decided not to sign the asset purchase agreement.

The lawsuit

The bankruptcy trustee sued the buyer for damages. The buyer claimed that it had no liability because it never signed the asset purchase agreement. The bankruptcy court ruled in the trustee’s favor and the buyer appealed the decision to Virginia federal district court.

That court ruled in the trustee’s favor: “A sale order ‘is the judicial sanction of the court,’ and upon its entry ‘the purchaser is entitled to the full benefit of his contract, which is no longer executory but executed, and which will be enforced against him and for him.’”

This case is referred to as In Re Redskins Grille 1, LLC, Nos. 19-cv-00633 (LMB/MSN), 18-01045-KHK, United States District Court, E.D. Virginia, Alexandria Division (February 27, 2020).  

Comment

With 20/20 hindsight, the buyer would have been better off if it had tried to negotiate with the landlord to agree to modify the lease instead of forcing a lease modification through the sales order. In that case, the buyer would have been free to walk if the landlord would not agree to a suitable lease modification.

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 bankruptcy sale, distressed business acquisitions, sales order, Section 363 sale Tagged with: ,

Asset Buyer Can’t Recoup its Stale Fraud-Breach Claims Against Earnout

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March 10, 2020

Introduction

It is not uncommon for a business buyer to find undisclosed problems in the acquired business after the closing; problems that the seller’s owner most certainly knew about. Nevertheless, the buyer often makes a business decision to forego a fraud/breach claims against the seller’s owner; especially if the seller’s owner has been hired to grow the business.

That might have regrettable consequences for the buyer if the deal can’t be salvaged.

The deal

This case involved the 2011 acquisition of a medical device company by a publicly traded company. The buyer acquired the target company in a merger for $10 million in cash and $22.5 million in buyer stock. Furthermore, the sellers could receive earnout payments in buyer stock upon the achievement of future milestones.

The lawsuit

The buyer learned after the closing (in 2012) that the target products had many undisclosed problems. Buyer, however, decided not to sue the owners (who stayed after the closing); fix the defects; and get FDA approval of the product.

The product fixes took some time. Buyer secured FDA approval in 2019; the first merger agreement milestone triggered a buyer payment to the owners of $2.375 million in buyer stock.

The buyer refused to pay the earnout, and the dispute ended up in the Court of Chancery of Delaware. Buyer conceded that it was too late under Delaware’s statute of limitations to bring a claim against the owners for fraud or breach of the merger agreement’s representations and warranties. Instead, the buyer sought to recoup or offset its damages the buyer suffered as a result of the owners lying about the problems with the medical devices against the earnout payment.

The owners argued that the buyer could not recoup its stale claims against the earnout, and the court agreed; finding that the alleged owner fraud and contract breach had little to do with whether the owners were entitled to the earnout. The court said it made “little sense as a matter of policy” to permit the buyer “to sit on its contractual rights and wait until” the FDA has approved the medical device. By that time, much of the evidence pertinent to the fraud and contract breach claims, such as testimony “might be unavailable or less reliable, and … (the owners) … might be unable to mount a successful defense.”

This case is referred to as Claros Diagnostics, Inc. v. OPKO Health, Inc., C.A. No. 2019-0262-SG, Court of Chancery of Delaware (Decided: February 19, 2020).  

Comment

Not pursuing a post-closing claim may have its advantages, but in the calculation always remember that the expiration of a statute of limitation has real consequences. In most circumstances, the defrauded buyer will not be able to offset damages buyer suffered from an expired claim against post-closing seller payments.

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 outs, recoupment doctrine, statute of limitations Tagged with: ,

Buyer of Assets of LLC Business Can Sue Seller LLC Member Personally for Seller Breach

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February 28, 2020

Introduction

Ordinarily the owner of corporation or LLC who sells the company’s assets is not personally liable to the buyer for his or her company’s asset purchase agreement obligations unless he or she signs the APA as a party or guarantees the company’s APA obligations. But there is an exception for the owner’s bad behavior.

The deal

This case involves the sale of three trampoline parks: in California, New Jersey and New York. Each park was operated by a separate LLC and the founder of the parks was the ultimate principal owner in each LLC. His controlling interest in each selling LLC was through holding companies which were also limited liability companies.

The founder sold the 3 parks to the same buyer in 3 simultaneous closings of 3 asset purchase agreements. The purchase price was based upon a multiple of the combined EBITDA of the parks and the historic and projected earnings for the 3 parks determined the multiple that was used in determining the purchase price for each of the parks.

The lawsuit

To buyer’s surprise, two competitor trampoline parks opened within 13 miles of the seller’s New Jersey Park; one immediately before the closing and the other park within several weeks after the closing. The founder had known about the two competing New Jersey parks but had not disclosed this to the buyer prior to the closing. This was a serious omission because the EBITDA multiplier that was used was based upon a bundled transaction and the New Jersey park contributed the greatest amount of the bundled EBIDA; which in turn drove a higher multiplier for the 3 transactions.

The New Jersey competition, if known by the buyer, would have significantly depressed earnings forecasts and would have either blown the deal or led to a much lower EBITDA multiplier and a lower purchase price for each park.

The undisclosed New Jersey competition led to litigation, including a buyer claim in a California federal district court against the park’s founder for breach of the California asset purchase agreement’s seller representations and warranties.

The buyer alleged that the founder’s manufacturing company (not a party to the three transactions) entered into an agreement to design and outfit one of the New Jersey competitor’s facility with trampolines, platforms, climbing walls, and foam pits three months before the founder’s selling companies entered into the three APAs with the buyer. Furthermore, even earlier, the other New Jersey competitor contacted the founder’s manufacturing company as a potential trampoline vendor for its upcoming New Jersey facility.

The buyer claimed that the founder breached the California seller’s representations and warranties in the California APA by failing to disclose these competing New Jersey parks. The founder said that even if it is true that certain seller reps and warranties were breached; they were breached by the selling California LLC, not by the founder.

The buyer agreed that the founder was not a party to the California APA nor was founder a guarantor of the California LLC seller’s APA obligations. Nevertheless, the buyer said the founders LLC which held a controlling interest in the California seller was a party to the California APA; and that the founder signed the California APA on behalf of this LLC, as its manager.

Furthermore, buyer argued that the founder had personal liability for this LLC because of founder’s alleged bad behavior under California Corporations Code § 17703.04(b). That law provides that a member or manager of an LLC may be personally liable for the debts, liabilities and obligations of the LLC pursuant to common law alter ego principles “under the same or similar circumstances and to the same extent as a shareholder of a corporation.

The court agreed with the buyer and refused to dismiss the buyer’s breach of contract claim against the founder. The court said that typically, members or managers of a California limited liability company cannot be personally liable on a contract signed on behalf of the limited liability company.

But here, the buyer alleged founder engaged in fraudulent inducement or tortious conduct. The court described the conduct: the founder personally approached the buyer with the proposed bundled transaction; marketed and solicited the sale of the three facilities as a bundled transaction; the founder had ownership rights in each of the 3 facilities; the common multiplier for the 3 facilities was based upon founder’s disclosures; the founder contracted with one New Jersey competitor to design and outfit its facility before the closing; the other New Jersey competitor contacted the founder before the closing for potential trampoline services; during due diligence the founder stated in writing that he was not aware of new competitors that would be within 25 miles of the New Jersey facility; one New Jersey competitor opened its facility a week before the closing; and the other New Jersey competitor opened two-to-three weeks after the closing.

The court concluded that the buyer sufficiently alleged that the founder “engaged in tortious conduct to invoke personal liability under California Corporation Code § 17703.04. Accordingly, the … (founder’s) … motion to dismiss the breach of contract claim will be DENIED.”

This case is referred to as Rush Air Sports, LLC v. RDJ Group Holdings, LLC, No. 1:19-cv-00385-NONE-JLT, United States District Court, D. Colorado (February 14, 2020).  

Comment

This is a reminder to a business owner that a corporation or LLC does not always shield the owner from liabilities of his or her company.

This deal has generated several court decisions. Here is my October 19, 2019 blog about an earlier development of this case: http://www.mk-law.com/wpblog/fraud-carve-out-in-apas-exclusive-remedy-provision-saves-buyers-employee-non-solicitation-claim/

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 alter ego, breach of contract, breach of representations and warranties, representations and warranties Tagged with: , , , , , , ,

Unwritten Promise to Manager of Share of APA Purchase Price May Be Enforceable

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February 19, 2020

Introduction

It is not unusual for the seller of a business, to promise a key employee a share of the proceeds. Unfortunately, it also happens all too often that those promises do not end up in written form.  They should be, because many contracts have to be writing and signed by the parties.

The deal

This case involves the sale of an international freight forwarder, which is a broker which moves freight for companies. The manager was responsible for all profit and loss, including maintaining and increasing the profitability of the seller.

The seller negotiated the sale of its assets for $7.5 million.

The lawsuit

The manager sued the seller after the deal closed and it ended up in a Kansas City, Missouri federal district court. The lawsuit was based upon a claimed oral contract between the manager and the seller. The manager said that one of seller’s obligations in the oral contract was an obligation to distribute to the manager $3 million of the purchase price.

The seller said there was no oral contract and even if there was an oral contract; it was unenforceable under the Missouri statute of frauds.

Under the statute of frauds, the agreement had to be in writing and signed the by the seller if the term of the agreement was in excess of one year or the contract could not be performed within one year.

In this case the contract did not have a term of more than a year and the contract could be performed within a year. In fact, the oral contract was made less than a year before the closing.

This case is referred to as Niday v. Bulloch, Case No. 19-00195-CV-W-ODS, United States District Court, W.D. Missouri, Western Division (Filed January 30, 2020).  

Comment

The lesson here is to get it in writing, even if the oral contract is enforceable. A written contract has the advantage of being evidence of the deal and avoids risky, expensive and time-consuming he said/she said litigation.

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 oral contract, statute of frauds Tagged with: ,

Asset Seller Guarantor Must Pay Buyer’s $1.7 Million Legal Fees – But APA Said Buyer Pay Own Fees

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February 7, 2020

Introduction

Post-closing disputes in business acquisitions are common. One way of managing this legal risk is to deal with the question of whether the loser in such a dispute pays the reasonable legal expenses of the other party. Without an attorney’s fee provision, the loser usually has no obligation to pay the winner’s legal fees.

In this case, there was no attorney’s fee provision in the APA. Nevertheless, the buyer was awarded $1.7 million in attorney’s fees from a post-closing dispute.

The deal

The asset purchase agreement provided for dispute resolution by arbitration. That provision said that each party would pay their own attorney’s fees.

However, the parent of the seller guaranteed the seller’s obligations under the asset purchase agreement, under a separate agreement, a guaranty, where the guarantor promised to pay reasonable attorney’s fees, incurred by the buyer to enforce the buyer’s rights under the guaranty.

The lawsuit

The buyer won the arbitration and was awarded $1.7 million in attorney fees from the guarantor pursuant to the terms of the guaranty.  The guarantor challenged the arbitration award in a Manhattan federal district court and lost.

The parent company guarantor argued that under the guaranty agreement it promised to pay its subsidiary’s obligations under the APA; and since the subsidiary had no APA obligation to pay buyer’s attorney fees; then neither did the guarantor. The court said that the arbitrators award of attorney’s fees “should be enforced, despite a court’s disagreement with it on the merits, if there is a barely colorable justification for the outcome reached.”

The court found no basis to overturn the arbitrator’s rationale in awarding attorney’s fees. The court, in quoting the arbitrators said that “’all rights and remedies [under the Guaranty] and under the [APA] are cumulative and not alternative,’ meaning that the Guaranty provided remedies in addition to those provided for or permitted under the APA.”

This case is referred to as Summers Laboratories, Inc. v. Shionogi Inc., No. 19 Civ. 2754 (AT), United States District Court, S.D. New York (Filed January 27, 2020).  

Comment

In 20/20 hindsight, the seller’s parent should have modified the guaranty language to expressly state that the guarantor had no obligation under the guaranty to pay the buyer’s legal fees.

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 Attorney's Fee Provision, Guaranty Tagged with: , ,

Creative Stock Acquisition Cost $10 million in Tax Penalties & Additions Plus Interest

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February 3, 2020

Introduction

A stock sale of a business often yields the business owner a greater amount of after tax sales proceeds than a sale of assets. However, most buyers prefer the tax advantages of an asset acquisition. This case is an example of a “creative” transaction that tried to give the outside investors of the business a stock sale and the buyers an asset sale.

The IRS determined that this deal was in substance an asset sale of the company assets not a sale of stock by the outside investors. It resulted in a Tax Court approval of the imposition upon the outside investors of $10 million in penalties and additions, plus statutory interest.

An earlier case involved the management owners of the company. See “Court finds “midco transaction” stock deal in substance an asset deal and permits IRS to recover target corporation’s tax from its shareholders, http://www.mk-law.com/wpblog/court-finds-midco-transaction-stock-deal-in-substance-an-asset-deal-and-permits-irs-to-recover-target-corporations-tax-from-its-shareholders/

The deal

The company owned several middle market television stations, a production facility and several small market radio stations. The shareholders consisted of the founders and outside investors.

The founders decided to retire. They and the outside investors agreed that a stock sale would produce the greatest amount of after tax sales proceeds. However, buyers were only interested in an asset deal. Thus, a creative structure was devised where the shareholders sold the stock of the company to a professional facilitator for $117 million. The corporation (now owned by the facilitator) sold most of the television assets and production facility to one buyer for $168 million and the radio assets to another buyer for $7.5 million.

The lawsuit

The Internal Revenue Service audited the transaction and recast it, ignoring the stock sale between the outside investors and the facilitator and instead treated the deal as an asset sale of the corporation’s assets followed by a distribution of the sales proceeds to the outside investors and founders. As part of the audit, the IRS imposed $10 million on the corporation in penalties and additions. The penalties and additions were also subject to interest.

The corporation had no assets and did not pay the $10 million in tax penalties and additions, nor the interest. The IRS then used its transferee liability procedure under Internal Revenue Code Section 6901 to collect the penalties, additions and interest from the outside investors.

The outside investors challenged the IRS actions in Tax Court and lost. The Court held that the transferee liability procedure could be used to collect the corporation’s tax penalties, additions, and interest, because the outside investors received sales proceeds owned by the corporation in exchange for nothing of value, at a time when the corporation was insolvent. This amounted to constructive fraud under the Wisconsin Uniform Fraudulent Transfer Act.

This case is referred to as Alta V Limited Partnership v. Commissioner of Internal Revenue, Docket Nos. 26828-08, 26829-08, 26865-08, 26867-08, United States Tax Court (Filed January 13, 2020).  

Comment

The sale of the business was structured as a “midco transaction”; a deal where there is a middle person that first buys the stock of the company from the owners; followed by the company’s sale of its assets to the intended buyer.  The risk of doing this “creative” tax planning involved not only additional taxes, but significant tax penalties, additions, and interest.

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 vs stock deal, midco transaction, tax penalties and additions, transferee liability for taxes IRC Section 6901, Uniform Fraudulent Transfer Act or Uniform Voidable Transfer Act Tagged with: , ,

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