Hawaii federal court says that seller of convenience stores cannot discharge his deal fraud liability in bankruptcy

Corporate entities controlled by Seller sold a chain of convenience stores and related assets to corporate entities controlled by Buyer. This sale was governed by a stock purchase agreement. The stock purchase agreement required that Seller submit a working capital estimate to Buyer, which would determine the amount of cash Buyer would have to pay Seller at closing. Buyer thought the working capital estimate Seller submitted was much too low. Thus, Buyer refused to pay Seller additional money.

Seller filed suit against Buyer in state court to compel him to pay money Seller believed he was owed under the stock purchase agreement, and Buyer counterclaimed, alleging, among other things, that Seller’s low working capital estimate was the result of Seller’s fraud.

Following the trial, the trial court entered a written order finding that the low working capital estimate was a result of Seller’s fraud, and that Seller had committed fraud because the stock purchase agreement set up an arrangement making Seller “Construction Manager” of certain projects, which Buyer had to pay him for, but Seller had no intention of ever serving as “Construction Manager” or doing anything that might entitle him to that money. The trial court awarded Buyer approximately $150 million in damages, of which approximately $85 million was compensatory damages for Seller’s fraud in the inducement—inducing Buyer to enter into the transaction with Seller to buy Seller’s company.

Buyer and Seller subsequently agreed to settle their dispute. Under the settlement agreement Seller agreed to execute a confession of judgment in the amount of $85 million that Buyer could file with the state court (and thus make enforceable) without prior notice to Seller, in the event Seller defaulted on his payment obligations under the settlement agreement. The confession of judgment included the portions of the state court’s written order following trial finding that Seller committed fraud.

Seller defaulted on his obligations under the settlement agreement when Seller failed to make a required $4 million payment on time. Seller then asked Buyer to hold off on enforcing Buyer’s rights under the settlement agreement to give Seller more time to come up with the money. Buyer agreed, and the parties entered into a forbearance agreement. But then Seller also defaulted on the forbearance agreement.

After Seller defaulted on the forbearance agreement, Buyer filed the confession of judgment in state court. The clerk of the state court entered the judgment against Seller for $85 million, and the state court found the confession of judgment complied with applicable state law. The Nevada Supreme Court denied Seller’s challenges to the confession of judgment.

Shortly thereafter, Buyer, as a creditor of Seller, filed an involuntary bankruptcy petition against Seller. Buyer then filed a complaint against Seller in bankruptcy court seeking to establish that the $85 million confession of judgment against Seller was nondischargeable in bankruptcy. The bankruptcy court agreed with Buyer finding that the $85 million debt was nondischargeable under the bankruptcy law because it was a debt incurred as a result of fraud. Seller appealed to the federal district court and lost there too.

This case is referred to In Re Morabito, Case No. 3:18-cv-00221-MMD, United States District Court, D. Nevada, (January 22, 2019).

Comment. Committing fraud when selling or buying a business is more serious than simply breaching the terms and conditions of the purchase agreement. If there is fraud the other party may be able to recover damages well in excess of any negotiated indemnification cap on damages contained in the purchase agreement.

Furthermore, the party committing fraud may not be able to discharge the fraud liability in bankruptcy.

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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