Target is a manufacturer of retail shelving labels, based in Little Rock, Arkansas. Target was owned by Seller (an entity owned by two private equity firms).
During the summer of 2012, Seller put Target up for sale. A private equity firm created Buyer to bid on and potentially acquire Target. Buyer emerged as the winning bidder in Seller’s sale process, and the parties began negotiations.
In negotiating the sale, the parties focused on, among other things, the transaction tax deductions. Transaction tax deductions are transactional expenses (such as professional fees and compensatory payments for options cancellations or bonuses) incurred by Target, that can be claimed as tax deductions. Without special contract provisions, Seller would generally benefit from pre-closing transaction tax deductions and Buyer for post-closing transaction tax deductions.
Each side began with an attempt to seize the full value of the deductions. Seller’s first draft of the stock purchase agreement, sent in September 2012, proposed that Buyer pay to Seller 100% of the value of the transaction tax deductions as part of the purchase price. Buyer responded by striking the language in the draft so as not to bear the cost of the transaction tax deductions.
As a compromise, Seller decided to propose that the parties split the value of the transaction tax deductions. On October 3, 2012, Seller’s Investment Banker and Buyer discussed the transaction tax deductions, and Seller’s Investment Banker tentatively offered to split the transaction tax deductions down the middle.
Seller did not agree with its Investment Banker’s proposal, but later that day, Seller’s Investment Banker and Buyer had a follow-up conversation, during which Buyer and Seller’s Investment Banker agreed that 50% of transaction tax benefits would be paid to Seller as and when realized, as long as Seller would accept pre-closing tax indemnity.
During that conversation, Seller’s Investment Banker stated that the transaction tax deductions would be worth between $6-$7 million. After Seller’s Investment Banker conveyed the outcome of the conversation to Seller, Seller told him, good job on getting the split.
On October 4, 2012, Buyer sent an initial draft of the letter of intent to Seller that did not mention the transaction tax deductions. Seller returned an edited draft of the letter of intent into which it inserted a provision requiring Buyer to pay over to Seller 50% of the benefit of any transaction tax deductions on an “as and when realized” basis. The parties then signed the letter of intent.
Following the letter of intent, the lawyers took over drafting the stock purchase agreement. The attorneys exchanged ten drafts of the stock purchase agreement before the final executed version.
Buyer’s lawyer proposed several changes which were not ultimately incorporated into the stock purchase agreement. The provisions proposed by Buyer’s lawyer and rejected by Seller’s lawyer required Seller to file Target’s pre-closing tax forms without regard to the transaction tax deductions; required Seller to submit such Target tax return to Buyer in advance of filing; and allowed Buyer to retain 50% of the transaction tax deductions.
The final stock purchase agreement also included a Seller lawyer provision stating that in connection with the preparation of Target’s post-closing tax returns all transaction tax deductions would be treated as properly allocable to the pre-closing tax period ending on the closing date and such tax returns shall include all transaction tax deductions as deductions.
Target, Seller, and Buyer executed the stock purchase agreement on November 27, 2012.
On December 17, 2012, Target completed its fourth quarter tax payment of over $1 million to the IRS. Target’s CFO used an outside tax advisor to estimate Target’s tax liability. Target’s CFO believed that the transaction would close before the end of 2012, and thus, Target’s CFO included the value of the transaction tax deductions in making the tax payment.
The transaction closed on December 27, 2012.
On a February 21, 2013 conference call regarding the final net working capital adjustment, Buyer learned from Target’s CFO that there would not be a refund for Buyer from any transaction tax deductions because Seller claimed them pre-closing. On February 25, 2013, Buyer delivered a letter to Seller alleging breach of the stock purchase agreement. Seller’s reply letter denied any breach of contract.
The dispute ended up in Delaware state court, with Buyer accusing Seller of claiming the transaction tax deductions improperly. Finding the language of the stock purchase agreement ambiguous the court looked to the history of the negotiations, including Buyer lawyer’s proposed language that was not included in the stock purchase agreement.
The court concluded that even though the Buyer and Seller principals may have agreed upon a 50/50 split; the language to implement that part of the deal was never put in the stock purchase agreement. Buyer’s lawyer had proposed the above language that would have probably reflected this tax deal, but Seller’s lawyer did not accept the proposed language and Buyer’s lawyer did not push the matter with Buyer.
The result? Seller received 100% of the $6 million benefit of the transaction tax deductions.
This case is referred to as LSVC Holdings, LLC v. Vestcom Parent Holdings, Inc., C.A. No. 8424-VCMR, Court of Chancery of Delaware, (Decided: December 29, 2017).
Comment. Several lessons here. First, sharing tax benefits from a deal is very complicated business. Easier to agree with the big idea than describing it in the purchase agreement. Especially when, like in this case, there is a working capital purchase price adjustment.
The lesson is for the buyer principal and the buyer lawyer to be on the same page to make sure that the stock purchase agreement reflects the tax splitting deal reached by the principals.
A simpler way to share the tax benefit would have been for Buyer and Seller to agree for example that the tax benefit was $6M and then lob $3M off the purchase price. In that case, there would have been no stock purchase agreement language required to describe the tax benefit sharing deal.
By John McCauley: I help people start, grow, buy and sell their businesses.
Telephone: 714 273-6291
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