Buyer of Chemical Division Sues Seller for Understating Costs

Introduction

There are unique risks for a buyer when purchasing a division of a seller (called a divestiture). It is easier to assess the quality of earnings of a stand alone business than with a division where costs must be allocated to the division from the rest of the company.

The deal

Our seller was an Akron based private equity firm specializing in investments in distressed or underperforming middle market and mature companies. Through subsidiaries, it owned and operated a chemical division that chiefly sold research and development services to biotech, pharmaceutical, food, flavor, fragrance and specialty chemical customers.

The seller sold the chemical division to the buyer for $27 million. The buyer also agreed to pay the seller an earnout of $5.5 million if the business hit an earnings target for the first year after the closing.

The lawsuit

The buyer and seller’s relationship soured after the closing. The buyer was disappointed with the post-closing performance of the chemical division and the seller did not receive its earnout. They ended up in an Ohio federal district court.

The buyer accused the seller of understating the costs of the business. Specifically, the seller had represented and warranted that the 2016 business costs were as stated in a schedule attached to the asset purchase agreement.

The alleged understated costs related to seller’s allocation of companywide costs. There were two categories of disputed costs. One was administrative costs which were primarily, salary and benefits for sixteen employees working in human resources, finance and IT. The buyer said those costs should have been allocated by employee head count. They were not.

The second cost category was support group (quality assurance and product management). The buyer claimed that these costs should have been allocated by revenue. They were not.

The buyer stated that the seller used the headcount and revenue methods in its internal financials to allocate administrative and support group costs to the chemical division before the sale, and that the total of these 2016 costs allocated to the division in the internal financials totaled $2.3 million; not the $500K the seller represented and warranted were these costs in its representations and warranties. The buyer accused the seller of intentionally downplaying the chemical division costs to make the chemical division appear more profitable than it was.

The buyer asked the court to rule that the seller breached its representations and warranties in connection with the 2016 costs.

The seller denied that it misrepresented the costs of the chemical division. It argued that the costs represented in the agreement were not inaccurate because they were “pro forma” income statements. That is, the figures represent the hypothetical costs of the chemical division operated as a standalone company, not the actual costs incurred as a division of the seller. And because the assumptions and projections used to arrive at these pro forma estimates were detailed in the confidential offering memorandum, given to the buyer, the seller argued that the financial representations were sufficiently accurate and reasonable.

The court refused to rule that the seller understated costs at this stage of the litigation, saying that there is a material fact dispute regarding the buyer’s claim. On one hand, the seller stated that the figures represent all or substantially all the cost items of the business for the 12-month period ending December 31, 2016, suggesting that the schedule was meant to represent the chemical division’s actual 2016 costs. On the other hand, the schedule was labeled “Pro Forma FY 2018 income statement” and was described as “estimates” in the offering memorandum. Viewed in the light most favorable to the seller, this labeling sufficiently raises issues whether the seller’s representations were false.

The result is that the litigation goes beyond this preliminary legal skirmish.

This case is referred to Main Market Partners, LLC v. Olon Ricerca Bioscience LLC, Case No. 1:18-CV-916, United States District Court, N.D. Ohio, (April 9, 2019)  https://scholar.google.com/scholar_case?case=4976259500205573361&q=%22asset+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2017#r[17]

Comment

Could the buyer have discovered the historical cost allocation for the business before signing the asset purchase agreement through due diligence, such as through a quality of earnings assessment?

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

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