The seller of a business often gets the buyer to agree to limit the amount of buyer claims against the seller for breaches of the contract; whether it is an asset purchase, stock purchase, or merger agreement. And the claim limit may be substantial; even 10% or less of the transaction value.
Nevertheless, a buyer may discover after the closing that the buyer has substantially overpaid for the business because of target fraud. In such cases can the buyer recover more than the indemnification cap the buyer agreed to in the purchase or merger agreement? Sometimes.
The target in this case is an Orlando based cloud-based provider of travel distribution and passenger service system software. A buyer purchased the target in 2016 from its 100 or so shareholders for $120 million; which included a $9 million holdback, and a purchase price adjustment provision.
The buyer and the target shareholders ended up in the Delaware Court of Chancery after the closing. The buyer’s claims against the shareholders included a claim that the buyer substantially overpaid for the business; well in excess of the $9 million holdback; and that the buyer was entitled to recover the amount of the overpayment from the shareholders because the overpayment was caused by the fraud of the target’s chief executive officer.
The shareholders argued that buyer’s claim should be dismissed because the buyer agreed to limit its claim to the $9 million holdback and certain purchase price adjustment claims; pointing out that the only shareholder accused of fraud was the target CEO.
The target shareholders argued that the buyer’s unjust enrichment claim should be dismissed because the buyer seeks to hold the target shareholders personally liable for the target CEO’s alleged wrongs. The court rejected that argument saying that a Delaware unjust enrichment claim is permitted even when the target shareholders, who retain the benefit, are not wrongdoers.
Why? To deprive the target shareholders of benefits that in equity and good conscience the target shareholders ought not to keep, even though the target shareholders may have received those benefits honestly in the first instance.
This case is referred to Shareholder Representative Services LLC v. RSI Holdco, LLC, C.A. No. 2018-0517-KSJM, Court of Chancery of Delaware, (Decided: May 22, 2019)
It can be very difficult for a buyer that feels it has substantially overpaid for a company because of fraud to overcome the indemnity cap contained in the M&A documents. Under Delaware law, if the merger agreement comprehensively governs the target shareholders and buyer’s relationship, then the merger agreement (along with the indemnification cap) must provide the measure of the buyer’s rights and any claim of unjust enrichment will be denied.
But the merger agreement itself is not necessarily the measure of the buyer’s right where the claim is premised on an allegation that the merger agreement arose from the target CEO’s fraud and the target shareholders have been unjustly enriched by the benefits flowing from the merger agreement.
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).
Telephone: 714 273-6291
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