December 11, 2019
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.
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 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)
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
Telephone: 714 273-6291
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