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

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

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

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: , ,

Jilted Business Seller Awarded $5.7 Million Reliance Judgment

January 24, 2020

Introduction

“The promise given was a necessity of the past: the word broken is a necessity of the present.” Niccolo Machiavelli

The deal

This deal never saw a definitive acquisition agreement. The failed courtship ended up in a jury trial and the facts are as found by the jury.

The seller was a shipping broker for its clients’ large-scale North Dakota shipments of heavy-duty freight such as oil-field equipment and rigs. In March of 2013, the seller lost a lucrative contract. Without that business, the seller struggled financially. As a result, its owners planned to take their profits, close their operations in North Dakota, and return to Texas.

As part of closing shop, the seller contacted the buyer, a large trucking company, whom the seller regularly worked with, and told the buyer to take its trucks out of North Dakota because the seller would no longer be needing them. However, instead of taking the trucks back, the buyer expressed interest in buying the seller. The seller was open to the idea but told the buyer that the deal would need to happen quickly because the seller lacked enough cash to last long on its own.

The seller, who had “already shut the company down,” “cranked it back up” at the buyer’s request. The buyer sent the seller an Indication of Interest Letter. Since the initial conversation regarding purchasing the seller, the buyer was in near-constant communication with the seller about the purchase, routinely giving assurances that a deal would be finalized soon.

After two months, the buyer offered to buy the seller for $25 million. However, shortly after that the buyer’s group of companies were acquired and the new top management did not like the deal negotiated by the presidents of the buyer and the buyer’s parent company.

The seller continued to remind the buyer that it was running low on cash and needed the deal done quickly. Nevertheless, in the face of the buyer’s top management’s hostility to the deal, the presidents of the buyer and the buyer’s parent company continually reassured the seller that the deal was almost finalized. These assurances that the deal would eventually work continued for months, all while the seller continued to deplete its resources to keep the company operational for the buyer’s promised buyout.

Eventually, after eighteen months, the buyer top executives pulled the plug on the deal and the negotiations stopped. At this point, the seller had no money as it had been paying to keep the company afloat for over eighteen months. The seller, which was valued at $5.7 million eighteen months ago, now had no assets.

The lawsuit

The deal ended up in a Texas federal district court and the jury found that the buyer had promised to purchase the seller but never fully finalized the deal, instead stringing the seller along for over a year. The jury also found that the seller spent all of its cash—burning every last asset—at the buyer’s direction with constant assurances that the purchase would soon be finalized.

The seller’s successful legal theory was promissory estoppel: the seller spent millions in reliance on the ultimately broken promise that the buyer would take over soon. The judgment ordered the buyer to pay the seller $5.7 million for the cash the seller spent to stay in business in reliance of the buyer’s promise to buy the seller.

The buyer appealed and the federal Court of Appeals, 5th circuit, affirmed the judgment.

This case is referred to as Universal Truckload, Incorporated v. Dalton Logistics, Incorporated, No. 17-20725, United States Court of Appeals, Fifth Circuit (Filed January 3, 2020).  

Comment

The seller was not awarded $5.7 million in damages for buyer’s breach of contract. There was no contract. Nevertheless, a buyer must be careful what it says to a seller to keep the negotiations moving forward; especially if the seller’s business is distressed, and its net worth is a shrinking ice cube that may melt away as the due diligence and negotiations drag on.

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 promissory estoppel Tagged with: , , ,

Court Says Asset Business Buyer Can Sue the seller’s owner for Fraud

January 20, 2020

Introduction

“Things gained through unjust fraud are never secure.” Sophocles

The deal

The seller’s owner operated a business that helped clients obtain wholesale automobile dealership licenses for auto dealerships in Missouri through seller a limited liability company. The business consisted of setting up dealership entities, providing office space, providing logistical support, and assisting with dealership licensing, administrative functions, and books and records for auto dealership customers.

On May 1, 2018, the buyer entered into an asset purchase agreement with the seller to purchase its assets and the assets of a related company for $1.25 million, mostly in cash at closing.

During the sale negotiations, the seller’s owner told the buyer’s owner that the seller’s business had customers and was operational. In the asset purchase agreement, the seller represented that at the time of execution, there were no actions pending, or, to the seller’s knowledge, threatened before any court or governmental or administrative body or agency affecting these assets.

The lawsuit

Unbeknownst to the buyer, however, there were regulatory and licensing decisions against clients of the seller in Missouri at the time the asset purchase agreement was executed. Months before the asset purchase agreement was signed, the Missouri Department of Revenue determined that the seller’s client applicants were denied franchise auto dealership licenses because the rented space and services offered by the seller did not satisfy Missouri licensing requirements. The seller’s clients were actively litigating and seeking declaratory relief in Missouri to challenge the Department of Revenue’s licensing denials.

The seller’s owner was aware of the ongoing litigation at the time the asset purchase agreement was executed, but he never told the buyer about any pending or threatened litigation or regulatory actions affecting the seller’s ability to operate in Missouri. The seller’s owner was aware that one of his employees had been deposed in connection with the litigation and he was aware that the seller’s clients had requested that the seller pay their attorneys’ fees. The seller’s owner retained legal counsel in Missouri to represent Seller and its customers in the declaratory relief litigation, and he was receiving copies of legal filings months before the asset purchase agreement was signed.

The declaratory judgment litigation was ultimately unsuccessful, and at least seven of the seller’s clients were denied dealership franchise licenses. The result of the litigation “effectively ended” the seller’s ability to operate in Missouri.

The buyer sued the seller’s owner for fraud in a Chicago federal district court. The buyer claimed that it had suffered significant financial loss as a result of the seller’s owner’s failure to disclose the Missouri licensing problems before the sale.

The seller’s owner personally negotiated the deal with the buyer’s owner. After the sale, the seller’s owner withdrew all the money paid from the asset purchase agreement, transferred it to personal accounts, and “effectively shut down” his company.

The buyer did not sue the seller’s owner for breach of the asset purchase agreement. Apparently, the seller’s owner was neither a party to the agreement nor a guarantor of his company’s obligations under the agreement.

The seller’s owner argued that it had no liability for his failure to disclose the problems with his business and asked the court to dismiss the buyer’s fraud claim.

The court said that under applicable Indiana law, the essential elements of common law fraud are: (1) a material representation by the seller’s owner of facts about his business which; (2) which were false; (3) were made with seller’s owner’s knowledge or reckless ignorance of their falsity; (4) were made with intent to deceive the buyer; (5) were rightfully relied upon by the buyer; and (6) proximately caused injury to the buyer.

The court dismissed the fraud claim on a technicality—that the buyer failed to allege that the misrepresentations were made with intent to deceive. But, the court said, the buyer’s fraud claim against the seller’s owner would be allowed to proceed if “this simple issue is remedied in an amended complaint.”

This case is referred to as US Dealer License, LLC v. US Dealer Licensing LLC., No. 19 C 3471, United States District Court, N.D. Illinois, Eastern Division (December 23, 2019).  

Comment

The buyer’s problem here was that its only recourse for the misrepresentations under the asset purchase agreement was against a shell company. What could the buyer have done to minimize this risk?

Several tools: most straight forward would be an escrow of part of the purchase price; and a personal guaranty by seller’s owner of the seller’s obligations under the acquisition documents.

With 20/20 hindsight the buyer, as part of its due diligence, could have conducted a record search in Missouri for litigation involving the seller and its clients, and the status of the seller’s clients past and pending licensing applications with the Missouri agencies involved in the wholesale auto dealer licensing process, the Missouri Department of Revenue.

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 fraud in business sale Tagged with: , ,

Ambiguous APA Forum Selection Clause Did Not Waive Right to Remove to Federal Court

January 10, 2020

Introduction

Acquisition documents often have a forum selection clause. And like any provision ambiguity can invite a dispute if litigation breaks out after the closing.

The deal

The seller was a manufacturing company located in Butler County, Ohio. It sold its assets to the buyer in a multi million-dollar deal, which was documented by an asset purchase agreement.

The lawsuit

After the sale, seller sued the buyer in the Butler County Court of Common Pleas in anticipation of an alleged breach of the asset purchase agreement. The buyer removed the suit to a federal court sitting in Cincinnati, which is not in Butler County.

The seller asked the court to remand the lawsuit back to the state court in Butler County. The buyer resisted the request and both buyer and seller referred to the asset purchase agreement’s forum selection clause to support its position.

The provision said: “ANY LEGAL SUIT, ACTION, OR PROCEEDING ARISING OUT OF OR BASED UPON THIS AGREEMENT, THE OTHER TRANSACTION DOCUMENTS, OR THE TRANSACTIONS CONTEMPLATED HEREBY OR THEREBY MAY BE INSTITUTED IN THE FEDERAL COURTS OF THE UNITED STATES OF AMERICA OR THE COURTS OF THE STATE OF OHIO IN EACH CASE LOCATED IN THE COUNTY OF BUTLER, AND EACH PARTY HERETO IRREVOCABLY SUBMITS TO THE EXCLUSIVE JURISDICTION OF SUCH COURTS IN ANY SUCH SUIT, ACTION, OR PROCEEDING . . . . THE PARTIES HERETO IRREVOCABLY AND UNCONDITIONALLY WAIVE ANY OBJECTION TO THE LAYING OF VENUE OF ANY SUIT, ACTION, OR ANY PROCEEDING IN SUCH COURTS AND IRREVOCABLY WAIVE AND AGREE NOT TO PLEAD OR CLAIM IN ANY SUCH COURT THAT ANY SUCH SUIT, ACTION, OR PROCEEDING BROUGHT IN ANY SUCH COURT HAS BEEN BROUGHT IN AN INCONVENIENT FORUM.”

The court said that the forum selection clause was ambiguous. The clause said that any asset purchase agreement dispute should be resolved in a federal or state court in Butler County. However, the federal court does not sit in Butler County.

Given that ambiguity the court concluded that the most reasonable interpretation of the forum selection clause was that the parties agreed to resolve disputes in either a state court located in Butler County or a federal court having jurisdictions for Butler County disputes.

Given that conclusion, the seller argued that the buyer had waived its statutory right to remove the case to federal court. The court disagreed finding that buyer did not waive this right of removal. In other words, the lawsuit remained in the Cincinnati federal court.

This case is referred to as The Bidwell Family Corporation v. Shape Corp., Case No. 1:19-cv-201, United States District Court, S.D. Ohio, Western Division (December 9, 2019).  

Comment

The lesson here is clear. Be precise. If the seller wanted to litigate in Butler County alone the forum selection clause should not also provide for a federal court venue. Furthermore, the parties should have expressly waived the right to remove a Butler County state court dispute to a federal court.

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 forum selection clause, waiver of removal to federal court Tagged with: , , , ,

No Seller Indemnification Obligation to Buyer for Recall of Pre-Closing Product

December 19, 2019

Introduction

The buyer of a manufacturing company runs the risk of having to repair or replace a product made by the seller before the closing. One risk is the cost of a recall of a product line to deal with a significant design flaw.

The deal

The seller in this deal made recreational boats. It sold three brands of its bass fishing boats to a national outdoor recreational equipment retailer, for $260 million. $2.6 million of the purchase price was placed in escrow to secure the seller’s indemnification obligations under the Membership Interest Purchase Agreement. The escrow funds not required by indemnification had to be released to the seller by the first anniversary of the closing.

The lawsuit

After the sale, the buyer discovered that several purchasers of a particular line of boats included in the sale had presented warranty claims to the seller after noticing that the hulls of the boats had cracked or delaminated. The seller did not disclose the warranty claims or increase its warranty reserve in the financial statements provided to the buyer in connection with the purchase agreement.

The buyer determined the cracks and delamination in the hulls resulted from the seller having manufactured the boat hull with fewer layers of laminate than was called for in the boat’s design. The buyer also concluded that this production flaw affected an entire production run of boats and, therefore, case-by-case repairs would be inadequate to solve the problem. Instead, the buyer elected to replace the hulls of every boat produced with the allegedly defective hull. This decision prompted the buyer to initiate a “Replacement Program” whereby it recalled and replaced the hulls of every affected boat at an estimated total cost of $5 million.

The buyer notified the seller before the expiration of the one year escrow expiration period of a claim for indemnification under the purchase agreement, asserting that the seller’s failure to disclose the manufacturing defect and account for it in its financial statements breached certain of the purchase agreement’s representations and warranties. The buyer stated that its expected damages caused by the breach were $5 million.

The seller did not agree and after expiration of the one year escrow period demanded that the buyer consent to release the $2.6 million escrow fund. The seller refused and the dispute ended up in the Delaware Court of Chancery.

After trial the court concluded that the buyer had not proved that a product recall was not justified, because the problem could be solved by a much less costly repair or replacement of defective hulls on a case by case basis. Furthermore, the court found that the seller did not breach its financial, undisclosed or MAE rep, because the problem was not material. And although the seller breached a rep by not disclosing, the warranty claims, it was “no harm, no foul” because the seller’s reserve in its financial statements were more than adequate to cover the known claims.

The result? The court ordered the buyer to consent to the release of the escrow funds.

This case is referred to as Project Boat Holdings, LLC v. Bass Pro Group, LLC, C.A. No. 2018-0429-KSJM, Court of Chancery of Delaware (Decided: May 29, 2019. Revised: June 4, 2019)  

Comment

We don’t know whether the buyer asked a law firm experienced in post-closing M&A disputes, what the chances were that the buyer could recover the costs of the $5 million recall from the seller.

Also, we don’t know whether the buyer tried to include a provision in the purchase agreement obligating the seller to indemnify the buyer for any buyer loss arising out of any boats produced by the seller before the closing. That provision would have given the buyer more time to assess its exposure for the defective hulls; provided that the escrow agreement said that giving notice of product defects would extend the escrow period for an additional agreed term.

This additional language would have avoided all the fight about whether the seller breached its financial, undisclosed liability, MAE and warranty rep. Also, this provision is not breached until a claim is made and so does not accrue until then, not at closing.

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 breach of representations and warranties, financial representation and warranty, indemnification, indemnification for pre-closing product loss, MAE rep, No Undisclosed Liabilities, representations and warranties

Buyer’s Indemnification Claim Notice Tolled 1 Year Contractual but Not 3 Year Statutory Limitations Period

December 11, 2019

Introduction

The buyer of a privately held business often has a deadline to make an indemnification claim for the breach of a seller representation and warranty. This survival period in an acquisition agreement often expires sometime from the 1st to 2nd anniversary of the closing.

The deal

This deal was a stock acquisition. The target company designs and manufactures oil analyzers, which it sells and ships to customers.

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

The transaction closed on November 28, 2014. The buyer discovered the license problem after the closing. The buyer determined that of the 640 shipped analyzers containing unlicensed software, approximately 330 (the “legacy units”) remained in worldwide use after the closing.

On November 16, 2015, the buyer sent a letter to the seller claiming indemnification for breach of the IP representations. The claim notice cited the target’s “failure to procure and maintain appropriate software licenses” for its analyzers as the basis for the buyer’s claim.

On May 25, 2016, the buyer entered into a settlement with Microsoft. In exchange for a payment of $66,000, Microsoft released both the buyer and the target from claims relating to the unlicensed software used in the legacy units. Microsoft, however, did not release the end users of the 330 legacy units. This left the buyer and the target exposed to licensing related claims by the end users of the legacy units, particularly those end users who Microsoft may contact or sue.

On July 28, 2016, the buyer notified the seller of the buyer’s settlement with Microsoft with a demand for reimbursement for the amount the buyer paid Microsoft. The buyer also reserved its right to seek indemnification or future losses.

The lawsuit

The seller did not agree to indemnify the buyer and the dispute ended up in the Delaware Court of Chancery, with the buyer making a claim for indemnification, partly for breach of the IP representations. This claim was made on July 23, 2018. In that lawsuit the buyer claimed that it had suffered damages from the seller’s breach by settling with Microsoft and will probably also suffer further damages if Microsoft goes after the target’s end users of the legacy unlicensed software.

The seller asked the court to dismiss the indemnification claim for breach of the IP representations because it was made too late. The court said that under Delaware law, this claim accrued on the day of closing, November 28, 2014, and that the default statute of limitations was three years.  Thus, the court concluded, absent tolling, the statute of limitations barred the buyer’s July 23, 2018, indemnification claim for breach of the IP representations, because it was made after November 28, 2017— the 3rd anniversary of the closing.

In addition to the three-year statute of limitations, the court pointed out that the stock purchase agreement imposed a shorter one-year contractual limitations period for breach of the IP representations; meaning that the buyer had to make its indemnification claim for breach of the IP representations by November 28, 2015.

The buyer argued that its November 16, 2015 indemnification claim notice tolled both statutory 3 year and contractual 1 year limitations periods. In support of its tolling argument, The buyer pointed to a stock purchase agreement provision that said that the seller’s representations and warranties would survive the end of the agreement’s one year survival period if buyer gave notice of its claim to the seller prior to the expiration of the 1 year period.

According to the buyer, this provision served to toll both the contract’s one year and Delaware’s 3 year limitations periods until resolution of its indemnification claim. The court rejected this argument.

The court said that although parties may contractually agree to permit an indemnification notice to toll limitations periods until the underlying claim is resolved, this provision did not do that. This provision did not expressly provide for tolling Delaware’s three year statutory limitations period until the indemnification claim is resolved; just the tolling of the contractual one year limitation periods.

The result was the buyer’s July 23, 2018 indemnification claim for breach of the IP representations was time barred/

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

Comment

In the end it did not matter. That is because the stock purchase agreement also said that the seller had to indemnify the buyer for any loss the buyer suffered resulting from product shipped by the target before the closing.

Claims under this indemnification provision were not time-barred. “Indemnification claims based on third-party claims do not accrue until the underlying third-party claim is finally decided. In this case, the third-party claims by Microsoft were finally decided when … (the buyer) … settled those claims on May 25, 2016, and the three-year statute of limitations therefore ran until May 25, 2019—nearly a year after… (the buyer) … brought its … (indemnification claims) …. The potential, unasserted third-party claims by the legacy units’ end users are of course not finally decided, and the statute of limitations therefore has not yet begun to run on this aspect of” the buyer’s indemnification claims.

One other takeaway when Delaware law applies.  A buyer wanting the longest survival periods from indemnification should specify that an indemnification claim tolls both the probably shorter contraction limitation period contained in the purchase agreement and Delaware’s statute of limitation. Even more so since Delaware has extended the 3 year statute of limitations for contracts to 20 years for deals at least $100K in size. See 10 Del. Code § 8106(c)

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

Email:             jmccauley@mk-law.com

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

Telephone:      714 273-6291

 Legal Disclaimer

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

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

Monthly Financial Statements Not Covered by Financial Representation Covered by Books & Records Representation

Introduction

In mergers and acquisitions agreements, the seller generally represents and warrants that the target’s financial statements for its most recent fiscal year and its most recent interim financial statements are accurate and complete, consistent with operations, and prepared in according generally accepted accounting principles, consistently applied. The seller also represents and warrants in a separate provision that the target’s books and records are complete and correct.

The deal

This case involved the $224 million stock acquisition of an information services company from the sellers, father and son.

The lawsuit

After the closing the buyer claimed that the target had significantly overstated revenue in monthly financial statements that the sellers furnished the buyer which buyer reviewed before buying the company. These financial statements were not covered in the financial statement representation and warranty given by the sellers to the buyer.

Nevertheless, the buyer, in its Delaware lawsuit claimed that these monthly financial statements were covered by the representation and warranty of the sellers that the target’s books and records were accurate and complete.

The sellers denied liability claiming that the monthly financial statements were not “books and records” within the meaning of the books and records representation and warranty and could only be covered under their financial statement representation and warranty. The sellers argued that since their financial statement representation and warranty applied only to specifically enumerated financial statements and that the monthly financial statements were not included as part of the enumerated financial statements covered by the financial statement representation and warranty.

The Delaware Court of Chancery rejected the sellers’ argument: “I conclude … (the books and record representation and warranty) … covers the Monthly Financials to the extent the Monthly Financials are not included in … (the financial statements representation and warranty’s) … more specific representations. Consistent with foundational principles of contract interpretation, this construction harmonizes and gives meaning to both provisions at issue, obviating any need to prefer one over the other.”

This case is referred to as Hill v. LW Buyer, LLC., C.A. No. 2017-0591-MTZ, Court of Chancery of Delaware (Decided: July 31, 2019)  

Comment

This is not a surprising holding. The financial statement representation and warranty and the books and records representation and warranty both say that the covered material is correct and complete. But the financial statements representation and warranty goes farther saying that specified financial statements were also prepared according to GAAP, consistently applied.

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 books and records rep and warranty, financial representation and warranty Tagged with: , ,

Court Rules That EY Earnout Calculation Was Arbitration Not Expert Determination

Introduction

There are often post-closing calculations that must be made in an M&A deal. Examples are working capital and earnout calculations. Often the parties agree in advance to a dispute resolution procedure in the M&A documents in the event there is a disagreement over the calculation.

The deal

This case involved the stock acquisition of an Indiana engineering and consulting business. The purchase price was $21 million plus an earnout based upon EBITDA.

The lawsuit

The buyer calculated no earnout in the 2nd and final post-closing year. The seller disputed the calculation and the dispute was submitted to E&Y for resolution pursuant to the stock purchase agreement. E&Y calculated a 2nd year earnout of $3 million. The buyer refused to pay, and the dispute ended up in an Indiana trial court which agreed with E&Y. The buyer appealed to Indiana’s intermediate appellate court.

The stock purchase agreement’s earnout dispute resolution procedure said that E&Y should review “all relevant matters as it deems appropriate” and then deliver its calculation “which shall be final and binding upon” the buyer and the seller. The trial court confirmed this calculation as an arbitration award. The buyer claimed that under controlling Delaware law, the earnout calculation performed by E&Y could be looked at by the court because the dispute resolution procedure used was not an arbitration but an expert determination.

The court said that under Delaware law, the resolution of this issue depended upon whether the parties intended E&Y to act as an expert (meaning that it had authority to resolve factual but not legal issues) or as an arbitrator (which gave it the authority to resolve both factual and legal issues.) The buyer wanted to win the expert determination argument to give it life to poke legal holes in E&Y’s earnout calculation. The buyer’s fight would stop if E&Y acted as an arbitrator because then E&Y’s legal conclusions were final and binding on the court.

The court ruled that E&Y acted as an arbitrator of the earnout calculation dispute: We “have little difficulty concluding that the parties clearly and intentionally agreed to arbitrate earnout disputes … Although the term ‘arbitration’ does not appear, the agreement here delegates to … (E&Y) … broad authority to consider evidence, make determinations, and conclusively resolve any earnout dispute …”

The buyer argued that the earnout dispute resolution language showed that the parties agreed that E&Y’s calculation would be an “expert determination” of earnout disputes. The court rejected this argument. “Specific limiting language providing that … (E&Y) … is acting ‘as an expert and not as an arbitrator’ clearly narrows the scope of … (E&Y’s) … role and evinces the parties’ intentions that the auditor’s decision constitute an expert determination and not an arbitration. … There is no such stipulation or limiting language in the parties’ agreement here, leaving only language that clearly gives … (E&Y) … full and complete authority to act as an arbiter and issue a final and binding decision as to an earnout dispute.”

This case is referred to as SGS North America, Inc. v. Mullholand, No. 19A-PL-1283, Court of Appeals of Indiana (November 14, 2019)  

Comment

The bottom line is that the buyer did not get another shot to litigate the dispute in court. The judge noted what language in the purchase agreement would probably have won the buyer’s argument: “use of the expression `as an expert and not as arbitrator’ is now so common that it is difficult to conceive of a case in which a court would not treat those words as meaning exactly what they say.”

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 arbitration vs expert determination, dispute resolution provision, earn out, earn out dispute procedure, earn outs Tagged with: , , , , ,

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