Court permits stock buyer of company to sue sellers for pre-closing pension-insurance problems

Posted on by John McCauley

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.

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 compliance with all applicable laws, financial representation and warranty, representations and warranties

Seller of business had no obligation to subordinate its purchase money promissory note to buyer’s bank

Posted on by John McCauley

Target is a business located in Palo Alto, California, which specializes in the electro-plating of metal components for industrial uses. In the spring of 2014, Seller (the sole owner of all shares in Target) was approached by representatives of companies controlled by Buyer’s Owner regarding Seller’s interest in selling Target.

Buyer and Seller struck a deal and a stock purchase agreement was signed and the transaction closed on February 18, 2015. The stock purchase agreement provided for a $9.3 million purchase price. The purchase price was paid $2 million at closing; $3.5 million, called a post-closing down payment and subject to purchase price adjustments, in monthly installments until Buyer could obtain financing for the balance of the post-closing down payment; and the balance by a $3.8 million promissory note.

After the closing, Target applied for financing that was intended to provide funds to allow Target to pay Seller $1.5 million the post-closing down payment; which Target felt was the then balance after purchase price adjustments. In October of 2015, Target requested that Seller subordinate all of the indebtedness remaining due to Seller in favor of the bank. The subordination was a condition of the bank’s financing of $1.5 million of the post-closing down payment.

Seller refused. Seller and Buyer had never been discussed subordination during deal negotiations. In fact, Seller had insisted that Seller’s debt be secured in first position. And since the closing, Seller had lost trust in Target as a result of its failure to pay post-closing monthly payments in accordance with the stock purchase agreement.

This dispute among other issues ended up in a federal district court in San Jose, California. Target claimed that Seller was liable for breach of the implied covenant of good faith and fair dealing. Target’s claim for breach of the implied covenant of good faith and fair dealing was based on Seller’s obligation under the stock purchase agreement to execute and deliver such additional documents, instruments, conveyances and assurances and take such further actions as may be reasonably required to carry out the provisions of the stock purchase agreement and give effect to the transactions contemplated by the stock purchase agreement.

The court ruled for Seller finding no obligation to subordinate Seller’s debt to the bank.

The court noted that there was no express provision or requirement in the stock purchase agreement that Seller agreed to subordinate Seller’s debt to a bank in order to allow Target to secure financing to pay the post-closing down payment. The court concluded that Seller’s refusal to subordinate did not violate the stock purchase agreement or the implied covenant of good faith and fair dealing.

The court noted that the proposed bank financing agreement would have required Seller to subordinate all of Target’s indebtedness to Seller in favor of the bank. However, the proposed loan from the bank to Seller would have paid Seller only $1.5 million. This $1.5 million loan would not have paid Seller the full amount of the post-closing down payment, which was before adjustment $3.5 million, and would have not paid Seller any of the amounts due to Seller under the promissory note.

Thus, under the proposed financing agreement, Seller would have been required to subordinate to the bank all of the debts owed to Seller by Target, but the proposed loan to Target from the bank would have left a substantial balance due to Seller that was subordinated to the bank’s debt.

Moreover, at that point in time, Seller was mistrustful of Target and concerned about securing payment because Target had failed to fully honor its monthly payment commitments. The court found that these concerns were reasonable both objectively and subjectively under the circumstances.

Moreover, there had been no showing that Seller’s refusal to subordinate injured the right of Target to receive the benefits of the stock purchase agreement. The stock purchase agreement by its terms stated that if financing was not secured, Target would pay the post-closing down payment in monthly installments, and the promissory note provided that so long as Target continued to make the monthly payments in accordance with the stock purchase agreement, the annual payments that would otherwise be due under the promissory note would be deferred.

This case is referred to Hammon Plating Corporation v. Wooten, Case No. 16-CV-03951-LHK, United States District Court, N.D. California, San Jose Division, (September 25, 2017). https://scholar.google.com/scholar_case?case=8845586872299363938&q=%22stock+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2017

Comment. With 20/20 hindsight, Buyer should have asked Seller to subordinate deferred purchase price debt to bank financing. That might have opened up a constructive conversation on whether this deal made sense and avoided all the time, expense, and stress over a post-closing disputes on this issue.

By John McCauley: I help people start, grow, buy and sell their businesses.

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 implied covenant of good faith and fair dealing, promissory note, subordination

Court finds “midco transaction” stock deal in substance an asset deal and permits IRS to recover target corporation’s tax from its shareholders

Posted on by John McCauley

Sellers, a husband and wife duo, founded in 1985, and formerly owned (along with other shareholders) Target, a television and radio company. Target owned six radio stations, and six tv stations, one tv station in Minnesota and five tv stations in Wisconsin.

In conjunction with their retirement, Sellers wanted to sell Target. Target’s international accounting firm presented Sellers with analyses that compared the projected impacts on both buyers and sellers of a stock sale versus an asset sale. One such analysis, which assumed a value of $190 million for Target’s radio and television assets, showed net after-tax liquidation proceeds to Target shareholders of $94 million for a hypothetical stock sale, but only $75 million for the correlating proceeds of a hypothetical asset sale.

Sellers and Target liked a stock deal for its obvious tax advantages, but an asset deal would be more attractive to potential buyers because it would be very difficult to get a buyer to take both the 6 tv stations and 6 radio stations. Probably, the best price for selling Target would be to sell the radio stations to one buyer and the tv stations to another.

However, Sellers and the other shareholders preferred the greater net proceeds from a stock sale. And their advisers came up with a structure referred to in the trade as a “midco transaction”.

“Midco,” stands for “middle company,” and a midco transaction generally refers to a transaction in which Sellers and other shareholders would sell the Target stock (thus avoiding the triggering of built-in gain in Target’s appreciated radio and tv assets) while the buyer then sells Target’s assets, through use of an intermediary company.

Sellers were informed of a risk that the IRS might recharacterize the transaction as an asset sale. Their adviser on the structure of midco transactions, however, represented that none of the similarly structured transactions it had facilitated over an 18-year period had been successfully challenged or unwound.

Ultimately, Sellers with the help of advisers, sold their Target stock to a company run by a breakout specialist, who specializes in buying private companies and breaking up the assets in subsequent sales. The buyer then sold the five Wisconsin tv stations to an Illinois media company, the six radio stations to a Wisconsin radio company and the Minnesota tv station was distributed to Sellers.

The stock sale and the subsequent sale by the buyer of the tv stations all happened on May 31, 2001 within a span of less than three hours. The sale of the radio stations to a Wisconsin radio company occurred on September 21, 2001.

The transaction was very complicated involving Target, its shareholders, and four other entities. As a result, Target’s appreciated radio and tv stations were sold without generating any correlating tax liability to anyone.

In exchange for their Target shares, Sellers and a company Sellers owned ultimately received about $26 million. Sellers timely filed federal income tax returns for calendar year 2001 reporting gains from the May 31, 2001 sale of Target stock.

But this result was too good to be true. The IRS recast the transaction of Target (which had dissolved) as a sale by Target of its tv and radio assets, followed by a distribution of the sales proceeds to Sellers and the other shareholders as a liquidating distribution from Target.

This resulted in the IRS assessing Target with tax, penalties and interest of almost $79 million. However, Target no longer existed.

So, the IRS came after Sellers for the $26 million they had received from the transaction to recoup part of the $79 million tax liability the insolvent and now dissolved Target owed the IRS. The IRS based their claim on Internal Revenue Code section 6901.

The IRS said that under Section 6901, Sellers can be held liable for the taxes of Target. Sellers challenged the IRS claim in the U.S. Tax Court and lost and they appealed to the federal appellate court. Sellers also lost on appeal and thus were liable to pay over the entire $26 million sales proceeds to the IRS.

The court first said the IRS was correct in assessing Target the $79 million tax liability by recasting the stock sale into an asset sale because the deal was in substance an asset sale and the only purpose in doing a stock sale was to avoid taxes. The court then said that Sellers were liable for Target’s tax liability under Wisconsin’s fraudulent transfer law.

And Sellers were liable under Wisconsin’s law because Sellers received the sales proceeds which really were earned by Target when it in substance sold its assets; and the receipt of the sales proceeds by Sellers made Target insolvent.

This case is referred to as Shockley v. CIR, No. 16-13473, United States Court of Appeals, Eleventh Circuit, (October 3, 2017).

Comment. This stock deal was based upon an aggressive tax plan. Nevertheless, Sellers claimed that they did not know that this structure was aggressive and risky.

Seller’s accounting firm and the media broker were experienced and well-known advisers. Unfortunately, Seller’s claimed good faith and reliance upon experts did not matter under the Wisconsin fraudulent transfer law. It only mattered that the deal turned out not to work, triggering a large Target tax liability that rendered Target insolvent, and gave the IRS the right to come back after Sellers for their sales proceeds.

Federal income taxes are often by far the largest expense in doing a deal. And a deal structure that is very complicated and saves a bundle of the tax expense may be too good to be true. And if the deal blows up there is a real risk that the seller may be in a far worse position that had seller done a simpler transaction reflecting the substance of the deal, rather than getting cute.

By John McCauley: I help people start, grow, buy and sell their businesses.

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, transferee liability for taxes IRC Section 6901

Buyer of business loses misrepresentation claim against seller because claim was not based upon seller’s breach of contract

Posted on by John McCauley

Madison, Wisconsin based Target, is a contract manufacturer of custom vitamin and trace mineral premixes and value-added branded feed ingredients for the animal feed market. Seller was Target’s president and Buyer its vice-president. Both shared in Targets’ day-to-day operations, and each owned 50% of Target’ stock.

Buyer purchased Seller’s Target stock in 2012 pursuant to a stock purchase agreement. After the closing, Buyer claimed that he discovered that, prior to the execution of the stock purchase agreement, Seller made a series of misrepresentations.

The misrepresentations were: a Seller misrepresentation that Target owned all the equipment used in the business; Seller’s failure to include accounts payable information for inventory that was purchased and received in September 2011 on the Target’s balance sheet; Seller’s failure to disclose that a major Target customer would be significantly reducing its business with Target; and Seller’s failure to disclose that another major Target customer had decided to switch suppliers in 2012.

After discovering these alleged misrepresentations, Buyer refused to make payments that were due Seller under Buyer and Seller’s agreements. Seller sued Buyer in a Wisconsin state court for breach of contract (failure to make post-closing payments required under the purchase documents). Buyer counterclaimed, accusing Seller of breach of fiduciary duty and fraudulent inducement (intentional misrepresentation).

Seller challenged the Buyer’s claims, asserting, among other arguments, that the economic loss doctrine required Buyer to base its misrepresentation claim only upon a breach by Seller of the stock purchase agreement. In this case, Seller pointed out that Buyer was not basing its misrepresentation claim upon a breach of contract claim but upon the tort claims of breach of fiduciary duty and fraudulent inducement (intentional misrepresentation). The tort claims Seller argued were barred by the economic loss doctrine.

The trial court agreed with Seller and effectively dismissed Buyer’s claims against Seller and Buyer appealed. The Wisconsin intermediate appellate court also agreed with Seller.

The appellate court held that under the economic loss doctrine Buyer could only sue Seller for Seller’s breach of the stock purchase agreement, which Buyer was not doing. This result furthers the policies, among others, of protecting Buyer and Seller’s freedom to allocate the economic risk associated with the Target business; and to encourage Buyer, the party best situated to assess the risk of economic loss, to assume the risk, allocate the risk through the stock purchase agreement, or insure against that risk.

Furthermore, the court noted that Buyer was able to protect himself from the risks of the Target business. The court noted that (1) Seller and Buyer were sophisticated businesspersons who negotiated agreements primarily geared to Seller selling his ownership interest in the Target business to Buyer; (2) Seller and Buyer were represented by counsel; (3) Buyer made affirmative representations in the stock purchase agreement expressly indicating that he had sufficient knowledge and experience to evaluate the risks associated with purchasing Seller’s stock; and Buyer affirmatively represented  in the stock purchase agreement that Buyer had been actively involved in the management and financial affairs of Target and that Buyer had sufficient knowledge and experience in making investments so as to be able to evaluate the risks and merits of his investment in Target.

This case is referred to as Reinke v. Jacobson, Appeal No. 2016AP2197, Court of Appeals of Wisconsin, District IV, (October 26, 2017).

Comment. There are times when a buyer can’t sue a seller of a business for breach of the purchase agreement. Perhaps it is because the agreement prohibited buyer from making a claim beyond a certain date, and the buyer’s claim was made after the purchase agreements deadline for making claims; or that the agreement caps the amount that the buyer can recover from seller as a breach of the agreement, and buyer’s claim exceeds this cap. Or perhaps the misrepresentation was not in the purchase agreement but was a something seller said in negotiations or was data room material.

To get around these problems buyers often seek recovery from seller for fraud or misrepresentation, and not based upon a breach of the purchase agreement. The law in this area permits such suits under certain circumstances. But a buyer’s claim often does not fall into one of the exceptions and must rely on a breach of the purchase agreement claim.

By John McCauley: I help people start, grow, buy and sell their businesses.

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 economic loss doctrine, fraud in business sale, negligent misrepresentation, tort misrepresentation in M&A

Delaware court finds stock purchase agreement does not give buyer share of target’s transaction tax deduction benefits

Posted on by John McCauley

Target is a manufacturer of retail shelving labels, based in Little Rock, Arkansas. Target was owned by Seller (an entity owned by two private equity firms).

During the summer of 2012, Seller put Target up for sale.  A private equity firm created Buyer to bid on and potentially acquire Target. Buyer emerged as the winning bidder in Seller’s sale process, and the parties began negotiations.

In negotiating the sale, the parties focused on, among other things, the transaction tax deductions. Transaction tax deductions are transactional expenses (such as professional fees and compensatory payments for options cancellations or bonuses) incurred by Target, that can be claimed as tax deductions. Without special contract provisions, Seller would generally benefit from pre-closing transaction tax deductions and Buyer for post-closing transaction tax deductions.

Each side began with an attempt to seize the full value of the deductions. Seller’s first draft of the stock purchase agreement, sent in September 2012, proposed that Buyer pay to Seller 100% of the value of the transaction tax deductions as part of the purchase price. Buyer responded by striking the language in the draft so as not to bear the cost of the transaction tax deductions.

As a compromise, Seller decided to propose that the parties split the value of the transaction tax deductions. On October 3, 2012, Seller’s Investment Banker and Buyer discussed the transaction tax deductions, and Seller’s Investment Banker tentatively offered to split the transaction tax deductions down the middle.

Seller did not agree with its Investment Banker’s proposal, but later that day, Seller’s Investment Banker and Buyer had a follow-up conversation, during which Buyer and Seller’s Investment Banker agreed that 50% of transaction tax benefits would be paid to Seller as and when realized, as long as Seller would accept pre-closing tax indemnity.

During that conversation, Seller’s Investment Banker stated that the transaction tax deductions would be worth between $6-$7 million. After Seller’s Investment Banker conveyed the outcome of the conversation to Seller, Seller told him, good job on getting the split.

On October 4, 2012, Buyer sent an initial draft of the letter of intent to Seller that did not mention the transaction tax deductions. Seller returned an edited draft of the letter of intent into which it inserted a provision requiring Buyer to pay over to Seller 50% of the benefit of any transaction tax deductions on an “as and when realized” basis. The parties then signed the letter of intent.

Following the letter of intent, the lawyers took over drafting the stock purchase agreement. The attorneys exchanged ten drafts of the stock purchase agreement before the final executed version.

Buyer’s lawyer proposed several changes which were not ultimately incorporated into the stock purchase agreement. The provisions proposed by Buyer’s lawyer and rejected by Seller’s lawyer required Seller to file Target’s pre-closing tax forms without regard to the transaction tax deductions; required Seller to submit such Target tax return to Buyer in advance of filing; and allowed Buyer to retain 50% of the transaction tax deductions.

The final stock purchase agreement also included a Seller lawyer provision stating that in connection with the preparation of Target’s post-closing tax returns all transaction tax deductions would be treated as properly allocable to the pre-closing tax period ending on the closing date and such tax returns shall include all transaction tax deductions as deductions.

Target, Seller, and Buyer executed the stock purchase agreement on November 27, 2012.

On December 17, 2012, Target completed its fourth quarter tax payment of over $1 million to the IRS. Target’s CFO used an outside tax advisor to estimate Target’s tax liability. Target’s CFO believed that the transaction would close before the end of 2012, and thus, Target’s CFO included the value of the transaction tax deductions in making the tax payment.

The transaction closed on December 27, 2012.

On a February 21, 2013 conference call regarding the final net working capital adjustment, Buyer learned from Target’s CFO that there would not be a refund for Buyer from any transaction tax deductions because Seller claimed them pre-closing. On February 25, 2013, Buyer delivered a letter to Seller alleging breach of the stock purchase agreement. Seller’s reply letter denied any breach of contract.

The dispute ended up in Delaware state court, with Buyer accusing Seller of claiming the transaction tax deductions improperly. Finding the language of the stock purchase agreement ambiguous the court looked to the history of the negotiations, including Buyer lawyer’s proposed language that was not included in the stock purchase agreement.

The court concluded that even though the Buyer and Seller principals may have agreed upon a 50/50 split; the language to implement that part of the deal was never put in the stock purchase agreement. Buyer’s lawyer had proposed the above language that would have probably reflected this tax deal, but Seller’s lawyer did not accept the proposed language and Buyer’s lawyer did not push the matter with Buyer.

The result? Seller received 100% of the $6 million benefit of the transaction tax deductions.

This case is referred to as LSVC Holdings, LLC v. Vestcom Parent Holdings, Inc., C.A. No. 8424-VCMR, Court of Chancery of Delaware, (Decided: December 29, 2017).

Comment. Several lessons here. First, sharing tax benefits from a deal is very complicated business. Easier to agree with the big idea than describing it in the purchase agreement. Especially when, like in this case, there is a working capital purchase price adjustment.

The lesson is for the buyer principal and the buyer lawyer to be on the same page to make sure that the stock purchase agreement reflects the tax splitting deal reached by the principals.

A simpler way to share the tax benefit would have been for Buyer and Seller to agree for example that the tax benefit was $6M and then lob $3M off the purchase price. In that case, there would have been no stock purchase agreement language required to describe the tax benefit sharing deal.

By John McCauley: I help people start, grow, buy and sell their businesses.

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 sharing transaction tax deduction benefits

Seller did not have to disclose to buyer receipt of customer notice of nonrenewal of material contract

Posted on by John McCauley

Buyer is a company headquartered in Boulder, Colorado. Buyer is a publicly traded company that provides high-capacity dark fiber, wavelength, IT infrastructure services and ethernet products and services. Since its founding, it has made forty-one acquisitions of fiber and data center companies, averaging about three to four acquisitions per year.

Denver area-based Seller was a founded in late 2007. Before the execution of the stock purchase agreement, Seller owned all of the issued and outstanding stock of 3 subsidiaries (collectively, Target). At the time of the acquisition, Seller, through Target, offered a collection of IT infrastructure services, including data center colocation services, managed hosting services, and enterprise and public cloud services. It operated out of eight data centers in the United States, as well as a cloud storage platform in London.

Target’s customers’ needs naturally fluctuated over the duration of their relationship with Target. It was common for customers to require less storage space after they developed their own ability to perform the functions they had relied on Target to provide. As the expiration of their Target  contract term approached, Target customers routinely would negotiate new contracts with Target on more favorable terms. More-for-less was the mantra that Target sales force regularly confronted as customer contracts expired.

Target always aimed to renew customer contracts in order to lock down the resulting cash flow. With market prices declining, however, Target often needed to make concessions in order to keep customers. This meant that Target would have to accept either pricing discounts in return for restored space or a longer contract term. While not optimal, this strategy eventually created more guaranteed revenue.

Seller’s investors and the Seller board of directors decided by late spring 2014 that it was appropriate to consider strategic alternatives for Seller, including a sale of Target.

The day before Christmas Eve, 2014, Buyer sent Seller a letter of intent proposing to buy the Target stock. This proposal included a stock purchase agreement mark-up of Seller’s original draft.

Buyer proposed in its revised draft stock purchase agreement that Seller disclose any major Target customers that had given notice of nonrenewal of their Target contracts. Seller would not accept this language and Buyer let it go.

Buyer and Seller executed the stock purchase agreement on January 13, 2015, which provided for a $675 million purchase price. Buyer’s acquisition of the Target stock closed on February 23, 2015.

Buyer’s problems with the deal surfaced after the closing. Buyer was disappointed with Target’s post-closing performance. Buyer believed this was partly caused by 5 Target customers who had notified Seller before the closing that they were not going to renew their Target contracts or renew on less favorable terms. This was information that Seller never disclosed to Buyer before the closing.

Buyer sued Seller in a Delaware state court, claiming that Seller was obligated by the stock purchase agreement to disclose this information; specifically pointing to Seller’s representation and warranty provision that required Seller to disclose to Buyer any Target customer that was cancelling, terminating, materially modifying or refusing to perform a material contract.

The court did not buy the argument. The court said that the Seller representation and warranty requiring Seller to disclose to Buyer any Target customer termination, cancellation, or refusal to perform a material contract could require Seller to disclose to Buyer any customer that expressed an intent not to renew its Target contract, and that materially modify could include any customer that expressed an intent to negotiate for new terms in its Target contract.

On the other hand, the Seller representation and warranty requiring Seller to disclose any customer termination, cancellation, or refusal to perform a material contract could obligate Seller to disclose to Buyer only when a customer ends, or expresses an intent to end, a contract before the expiration of the contract’s current, non-renewed term, and “materially modify” could apply only to modifications of an existing contract as opposed to a potentially renewed contract.

Thus, the court concluded that the language was ambiguous and so it looked to the behavior of Buyer and Seller on the subject that occurred before the dispute broke out to see how they interpreted the provision. And that was bad for Buyer because Buyer had tried to include language in the stock purchase agreement requiring Seller to disclose any notice Target had received that a customer was not going to renew a material Target contract. The court said that Buyer would not have asked for this language, (which was rejected by Seller), unless Buyer thought that the disclosure of contract cancellations, terminations, or modifications did not cover contract nonrenewals.

The result: Buyer could not sue Seller for not disclosing the nonrenewals.

This case is referred to as Zayo Group, LLC v. Latisys Holdings, LLC, C.A. No. 12874-VCS, Court of Chancery of Delaware, (Decided: November 26, 2018).

Comment. The outcome does not seem fair. Buyer wanted Seller to tell it about pending nonrenewals. Seller refused even though Seller knew about renewals. Buyer closed, and Buyer finds out post-closing about the nonrenewals, and the resulting drop in value of Target.

Nevertheless, Buyer could not do anything about it unless Buyer’s nonrenewal language had been in the stock purchase agreement. As the court said, without an express Seller representation about nonrenewals buyer was accepting the risk that there were nonrenewals of material contracts.

By John McCauley: I help people start, grow, buy and sell their businesses.

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 Buyer beware, representation and warranty about customers, representations and warranties, stock purchase agreement

Stock sellers lose opening legal battle over buyer’s environmental claim

Posted on by John McCauley

In November 2007, Sellers of Target agreed to sell Target to Buyer through a stock purchase agreement. When the sale closed in December 2007, Sellers placed $16.7 million into escrow to secure any post-closing claims that Buyer might assert.

Target’s assets included a large facility in Muncie, Indiana.  Before 1965, one section of the facility served as a trucking terminal, complete with a fueling station and underground storage tanks. Several years after the Target sale closed, Buyer found previously undisclosed soil and groundwater contamination in that section of the facility.

Buyer wrote to Sellers in March 2011 about the contamination.  Specifically, Buyer told Sellers that the levels of benzene and vinyl chloride at the facility exceeded guideline levels set by the state of Indiana for soil and groundwater cleanup, and that Buyer needed to report the contamination to Indiana pursuant to the Indiana spill rule. Buyer reported the contamination to Indiana the same day it wrote to Sellers.

Indiana responded quickly and instructed Buyer to submit a written spill report as required under the Indiana spill rule. Less than two weeks later, Indiana—in accordance with Indiana statutes on hazardous substances—contacted Buyer again to ask Buyer to investigate the nature and extent of the contamination at the Muncie facility and submit another written report. Indiana also notified Buyer of potential civil penalties for failing to comply with its official request.

In April 2011, Buyer sent Sellers a claim notice based upon the stock purchase agreement’s indemnification provisions. That notice provided a preliminary estimate of Buyer’s costs for complying with Indiana’s cleanup requirements. Buyer gave Sellers an updated cost estimate a month later. Shortly after, the parties (who had already released most escrow funds) directed the escrow agent to keep $3.3 million in escrow pending further instructions.

In late 2011, Buyer agreed to enter the Muncie facility into Indiana’s voluntary remediation program, an alternative to the more rigid state cleanup program. Ultimately, under Indiana’s oversight and direction, Buyer investigated the facility further and developed a remediation plan. Pursuant to its statutory authority, Indiana reviewed and approved the final plan in July 2017. To the date of this court ruling, Buyer had incurred over $1.5 million in investigation and remediation costs.

Sellers claimed that it has no responsibility under the stock purchase agreement to indemnify Buyer for contamination; and asked a Chicago federal district court to so rule so that Buyer’s environmental claim would not hold up release of the remaining $3.3 million held in escrow. Early in the litigation Sellers asked the court to rule in its favor based upon the above facts and the language of the stock purchase agreement.

Sellers made technical arguments for its position which the court did not buy. The result: the case goes on.

This case is referred to as Hammond, Kennedy, Whitney & Co., Inc. v. Honeywell International, Inc., Case No. 16-cv-9808, United States District Court, N.D. Illinois, Eastern Division, (January 29, 2018).

Comment. A buyer is always concerned about unknown liabilities of the business to be acquired. One of the biggest unknown liabilities can be environmental liabilities.

In this case the unknown soil and groundwater contamination apparently came from a target owned a facility that before 1965, served as a trucking terminal, complete with a fueling station and underground storage tanks.

To protect Buyer, the stock purchase agreement required Sellers to represent and warrant that there were no environmental problems with the facility. The stock purchase agreement also obligated Sellers to indemnify Buyer if this was not true, and this promise was secured by an escrow of a significant portion of the purchase price.

Those provisions put Buyer in a strong position in this litigation.

By John McCauley: I help people start, grow, buy and sell their businesses.

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 environment representations and warranties, escrow, indemnification, representations and warranties

Stock buyer covered as successor to seller under target D&O policy

Posted on by John McCauley

On November 3, 2015, Buyer entered into a stock purchase agreement pursuant to which Buyer became the 100% shareholder of Target. After the sale closed, Buyer sent demand letters to Management Sellers, former Target Directors, seeking indemnification for financial misconduct allegedly committed by the Management Sellers prior to the sale of Target to Buyer.

The Management Sellers provided Insurer with prompt notice of Buyer’s demand letters and, in turn, demanded that Insurer provide the Management Sellers with a defense or indemnification under their director and officer liability insurance policies with Insurer. At the same time, the Management Sellers demanded indemnification from Target pursuant to the company’s bylaws.

These claims involving Buyer, Management Sellers, Target and Insured ended up in Delaware litigation. Subsequently, the Management Sellers and Buyer entered into a settlement agreement, pursuant to which Buyer was assigned all right, title, and interest in the Management Sellers’ claims in Management Sellers’ Delaware federal lawsuit against Insurer.

After the dust cleared one of the major disputes involved whether Buyer, as successor to Management Sellers, pursuant to the settlement agreement, was covered under Target’s director and officer liability insurance policy covering wrongful acts by Management Sellers during the negotiation of the stock purchase agreement. The dispute centered upon the major shareholder’s exclusion clause where the policy excluded coverage for claims made by a shareholder owning 5% or more of Target.

Insurer claimed that the coverage exclusion clause applied (and thus Buyer was not covered) since Buyer owned 100% of Target. Buyer disagreed and argued that the exclusion applied to claims made by Target shareholders who owned 5% or greater of Target when the alleged wrongful acts occurred (which was before Buyer acquired 100% of Target on November 3, 2015).

The court said that under applicable Delaware law, an exclusion in an insurance policy does not apply if the exclusion clause was ambiguous; because in cases of ambiguity, the court will interpret the clause against the interests of the drafter of the exclusion, Insurer, and in favor of Buyer, the insured. In this case the court held that the clause was ambiguous because both Buyer and Insurer’s interpretation of the exclusion clause was reasonable.

The bottom line: Buyer was covered under the D&O policy of Target for the wrongful acts of Management Sellers.

This case is referred to as EMSI Acquisition, Inc. v. RSUI Indemnity Company, C.A. No. 16-1046-LPS, United States District Court, D. Delaware, (January 31, 2018).

Comment. In this case, Buyer is seeking to recover some of its loss from the alleged breach of Management Seller’s stock purchase agreement representations and warranties from the Target’s D&O insurance policy.

By John McCauley: I help people start, grow, buy and sell their businesses.

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 ambiguous exclusion, directors and officers insurance policy, insurance coverage, major shareholders exclusion, stock purchase agreement Tagged with:

Court said it may be reasonable for business buyer to rely on seller oral representation about competition

Posted on by John McCauley

Target, based out of the Kansas City area, provides movie theater digital marketing/advertising and movie theater concessions. Sellers were the owners of Target. Buyer is a Texas capital investment limited liability company.

In early 2015, Sellers circulated a solicitation seeking to attract potential investors to purchase ownership interest in Target. Buyer responded to the solicitation and requested additional information on Target.

On June 4, 2015, Sellers sent Buyer an information memorandum which contained information about Target’s operations, information about Target’s financial records from previous years, and representations about Target’s predicted financial success moving forward.

On June 30, 2015, Buyer submitted a non-binding indication of interest to Sellers. In Buyer’s indication of interest, Buyer proposed that the purchase of Target eventually be consummated with a combination of equity provided by Buyer and conservative third-party senior debt. Sellers would stay on as Target employees following the purchase by Buyer.

The remainder of the deal is from the facts alleged by Buyer in court filings.

On August 25, 2015, Sellers and Buyer met in Overland Park, Kansas. Sellers presented details of Target’s operations to Buyer who, in turn, presented Buyer’s strategic vision for executing the purchase of Target. In this meeting, Buyer recognized Target’s digital marketing product line had significant competition from another market participant, Competitor. Because Competitor could impede Target’s growth in the digital marketing sector and pose a threat to the purchase of Target, Sellers orally represented to Buyer that Sellers had a close relationship with the president of Competitor and could reach a deal with Competitor which would alleviate the threat of competition.

Sellers and Buyer decided to actively work toward reaching a formal agreement for the sale of Target to Buyer. Accordingly, Sellers sent Buyer Target’s financial information to begin the due-diligence process and Buyer set out to obtain third-party investors.

Immediately following the August 25, 2015 meeting, Buyer contacted numerous investors to obtain third-party financing for the purchase of Target. In September 2015, Buyer obtained a non-binding commitment letter from Third-Party Investor — to support Buyer’ acquisition of Target. Buyer continued to solicit other third parties to participate in the purchase of Target as investors and/or strategic partners.

On September 4, 2015, Buyer submitted a proposed binding letter of intent to Sellers for the acquisition of Target.

On October 26, 2015, One of Sellers had a dinner meeting in Dallas, Texas with Buyer. Sellers represented for a second time that Sellers had a close relationship with Competitor executives and would strike a deal with Competitor to neutralize Target’s primary competition in the digital marketing sector.

On November 2, 2015, Sellers represented for a third time to Buyer, via email, that, by virtue of his relationship with Competitor’s executive team, Sellers were on the verge of reaching an agreement with Competitor that would virtually eliminate Target’s competition in the digital marketing sector.

On November 9, 2015, Sellers represented to Buyer for a fourth time that Sellers were on the verge of closing a deal with Competitor that would have game-changing implications for the growth of the company.

Buyer and Sellers executed the letter of intent on November 11, 2015. The letter of intent included a provision that Buyer’ obligation to complete the purchase of Target was subject to satisfactory due-diligence review of Target by Buyer and their lenders. The letter of intent obligated Sellers and Buyer to negotiate in good faith toward a definitive stock purchase agreement —and other documents incident to such purchase agreement—in conformance with guidelines provided in the letter of intent.

In December 2015, Buyer worked diligently with counsel to draft legal documents necessary for the closing of the purchase of Target. Sellers and Buyer negotiated and traded revisions to the definitive stock purchase agreement throughout January 2016. Although Buyer considered many of Sellers’ revision requests unreasonable or a deviation from industry standard, Buyer remained ready, willing, and able to consummate the purchase of Target.

By February 2016, negotiations broke down due to Sellers’ increasing demands regarding employment agreements, salaries for Sellers, and post-closing income tax distributions. Despite Sellers’ outward bad faith, Buyer had significant time and resources invested in the purchase of Target and thus were still ready, willing, and able to consummate the purchase of Target.

On March 1, 2016, Sellers and Buyer extended the exclusivity provision to March 15, 2016.

Sellers were never able to reach a deal with Competitor and Sellers ultimately sold Target to another buyer. Buyer then demanded payment from Sellers for fees incurred in connection with the purchase of Target. Sellers refused, and the dispute ended up in a federal district court in Kansas.

In the lawsuit Buyer claimed that Sellers negligently misrepresented that Sellers could reach an agreement with Competitor that would virtually eliminate Target’s competition in the digital marketing sector. Buyer claimed that Seller’s competition representation was a material factor in Buyer pursuing this deal.

Sellers early in the litigation asked the court to dismiss the claim, arguing that Buyer could not legally rely on Sellers competition representation since Buyer had the right under the letter of intent to conduct due diligence to determine for itself if Sellers competition representation was true.

The court disagreed, saying that under applicable Kansas law that it would be reasonable for Buyer to rely on Sellers competition representation unless Buyer knew or had reason to know of facts which made Buyer’s reliance unreasonable; which the court said was a question better resolved later when the court could consider all the facts surrounding Buyer’s decision to enter into the letter of intent and consummate the acquisition of Target.

This case is referred to as Cinema Scene Marketing & Promotions, Inc. v. Calident Capital, LLC, Case No. 16-2759-JAR, United States District Court, D. Kansas (February 9, 2018).

Comment. This case is a reminder to sellers to not overpromise when selling a business.

A seller can minimize seller’s exposure for optimistic statements made to buyer during negotiations, by keeping overly optimistic representations out of the seller’s definitive purchase agreement representations and providing in the purchase agreement an acknowledgement by buyer that buyer is only relying upon the seller’s representations contained in the purchase agreement.

By the way, the idea of a target talking to a competitor to reduce competition raises potential antitrust concerns. Talk to a competent antitrust lawyer before agreeing to go down that road.

By John McCauley: I help people start, grow, buy and sell their businesses.

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 anti-reliance clause, due diligence, extra-contractual fraud, negligent misrepresentation, reliance

Stock buyer of target and stock seller in post-closing fight over target’s cash

Posted on by John McCauley

Sellers incorporated Target in 1994 and owned all the shares of Target. Target’s assets consisted of two buildings in Old San Juan, Puerto Rico and two bank accounts at UBS. Through Target, Sellers rented the buildings—a commercial space and six apartment units. Sellers collected the rent money and deposited it into the two UBS bank accounts.

Sellers decided to sell Target, and they requested that their real estate broker set the asking price at $2 million. Following negotiations and receipt of another offer, Sellers agreed to sell Target for $1.8 million to Buyer.

On September 10, 2015, Sellers provided Buyer with Target financial information, which included a 2014 financial statement, 2014 income tax return, and Target’s 2014 annual report which it filed with the Puerto Rico Department of State. The financial information showed that Target had $219K in cash as of the end of 2014.

Two weeks later, Buyer and Sellers signed a stock purchase agreement, followed by an immediate closing. $180K was put in escrow to secure Seller’s indemnification obligations under the stock purchase agreement.

A dispute broke out after the closing after Buyer discovered that Sellers left no cash in Target. It ended up in litigation in a federal district court in Puerto Rico.

Buyer argued that it bought all the assets of Target (including its cash) when it bought all of Target’s issued and outstanding stock. Sellers argued that Buyer was only buying the real estate. The court looked at the stock purchase agreement and Target’s 2014 financial information and concluded it did not have enough evidence at this early state of the litigation to resolve the dispute. The result, the litigation will continue.

This case is referred to as Gazelle v. MR 314 Fortaleza LLC,, Civil No. 16-2500 (GAG), United States District Court, D. Puerto Rico (March 12, 2018).

Comment. In 20/20 hindsight, Buyer and Sellers could have eliminated this dispute by providing language in the stock purchase agreement that stated whether Target’s cash is part of the deal.

The issue is often resolved by using a post-closing purchase price adjustment which may be based upon a target’s net working capital, net worth, net assets, or another financial measure agreed to by seller and buyer.

By John McCauley: I help people start, grow, buy and sell their businesses.

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 book value adjustment, cash and cash equivalents, Description of business assets purchased, net working capital adjustment, purchase price adjustment, stock purchase agreement

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