Explore a real M&A case where lack of disclosure about customer issues led to a costly lawsuit. Learn the importance of transparency and diligence in mergers and acquisitions.
M&A Stories
March 15, 2019
Introduction:
In the world of mergers and acquisitions (M&A), understanding a target company’s relationship with its key customers is crucial. This article explores a real case where a lack of disclosure about customer issues led to a costly lawsuit.
Background:
In 2015, a private equity-owned company purchased another firm in the auto parts industry for $12 million. The buyer used a multiple of the target’s earnings to determine the price. The seller had assured the buyer that there were no problems with its key customers, which included one customer providing a significant 80% of the target’s revenue.
The Unpleasant Surprise:
After the deal was sealed, the buyer discovered that two of the target’s key customers, including the one providing 80% of revenue, were unhappy and had significantly reduced their purchases. This translated to an annual revenue decline of $500,000, a fact that the seller had concealed.
Legal Action:
Frustrated by this hidden problem, the buyer took the matter to a Delaware federal district court. They alleged breach of the seller’s stock purchase agreement’s representation and warranty regarding customer issues and also filed a claim for federal securities fraud due to the nondisclosure of these customer problems.
The Court’s Verdict:
The court ruled in favor of the buyer, emphasizing that the damages should account for the difference between the $12 million purchase price and the actual value of the company, considering the undisclosed customer revenue loss and the unstable customer relationships.
Why Securities Fraud?
You might wonder why the buyer pursued a claim of securities fraud in addition to the breach of the customer representation and warranty. One possibility is that the stock purchase agreement might have limited the buyer’s claims for breach, potentially capping them at a much lower amount, such as 10% of the purchase price.
Seller’s Defense:
The seller argued in court that it should not be held responsible for federal securities fraud since it was unreasonable for the buyer to rely solely on what the seller said about the target’s customer relationships. The seller contended that the buyer should have conducted a more thorough investigation and directly engaged with the key customers.
Court’s Ruling:
However, the court disagreed with the seller’s defense. It found that both the buyer and seller were focused on discretion to avoid alarming the target company’s employees and customers. Consequently, the court deemed it reasonable and necessary for the buyer to rely on the seller’s communications rather than reaching out to customers independently.
The Outcome:
In the end, the court awarded the buyer $4.4 million in damages, plus interest, highlighting the importance of transparency and diligence in M&A transactions.
Case Reference:
Heritage Handoff Holdings, LLC v. Fontanella, Civil Action No. 1:16-cv-00691-RGA, United States District Court, D. Delaware, (March 6, 2019).
By John McCauley: I help businesses minimize risk when buying or selling a company.
Email: jmccauley@mk-law.com
Profile: http://www.martindale.com/John-B-McCauley/176725-lawyer.htm
Telephone: 714 273-6291
Check out my book: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles
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