Seller was two related companies, one, a provider of litigation support and e-discovery services and the other, a provider of temporary legal staffing to law firms and corporations. Seller along with Seller Affiliate, a related company providing various litigation support services to litigators in New York City and Washington D.C., operated under common ownership as part of a litigation support and e-discovery business known as Superior Discovery.
Buyer, based in Chicago, also in the same business, is a wholly-owned subsidiary of Buyer’s Parent Company.
In 2014, Buyer began negotiating for and purchasing a number of e-discovery vendors and similar providers. Buyer’s Financing Source, a business development company, provided Buyer with financing.
After weeks of due diligence and negotiations, Buyer and Seller signed an asset purchase agreement. Buyer acquired substantially all of Seller’s assets for $9.9 million in cash and $2 million in preferred equity in Buyer’s Parent Company.
Among other things, the operating agreement provided for distributions and allocations of profit and loss with respect to the preferred equity. Distributions, however, were subject to any applicable agreement to which Buyer or Buyer’s Parent Company were indebted for borrowed money and to the retention and establishment of reserves for payment to third-parties such as the term loan agreement with Buyer’s Financing Source.
Seller had the right to seek up to $2 million in payment for the preferred equity at any time following the third anniversary of the date of issuance and only once there had been payment in full of all obligations outstanding under the term loan agreement and other term loan documents.
Seller also promised in the operating agreement that Seller would not sue Buyer’s Parent Company until payment in full of all obligations outstanding under the term loan documents.
Pursuant to the asset purchase agreement, moreover, Seller’s preferred equity were pledged to Buyer under a pledge agreement as collateral to secure certain indemnification obligations.
Seller and Buyer had a falling out after the closing. Seller claimed that Buyer before the closing, in supporting a $2 million valuation for the preferred equity to be given in the deal, forecasted Buyer’s Parent Company’s annualized forecasted revenue would be `$40 million in sales and $10 million in EBITDA (earnings before interest taxes depreciation and amortization).
Seller contended that it learned after the closing that such representations were false as Buyer’s Parent Company internal projections of annualized revenue were $33 million and that the figure included increased revenue predictions of acquisitions. Seller contended that that the $40 million figure was a complete fabrication by Buyer in an effort to convince Seller to accept the preferred equity.
Seller also had been told before closing by Buyer other misrepresentations that: (1) Buyer had a $10 million war chest for additional acquisitions, (2) Buyer had secured a $3 million revolving line of credit that would assist financing business operations after the acquisition of Seller and (3) that Buyer had a new lender that would allow for refinancing of the Buyer’s Financing Source loans within weeks.
Seller claimed that it relied on written and oral representations of Buyer, as it was not shown important documents related to the transaction. Seller contended that it was never shown the term loan agreement, on which its rights were contingent, and that Buyer made misrepresentations about its relationship with Buyer’s Financing Source and the term loan agreement. Seller further alleged that documents that were part of the asset purchase agreement and operating agreement and were referred to as exhibits were not actually shown to Seller because Buyer claimed that the documents were confidential due to simultaneous acquisitions and discussions with Buyer’s Financing Source.
Seller sued Buyer in a Manhattan court for fraud, among other claims, and Buyer asked the court to dismiss the fraud claim. The court dismissed the fraud claim.
The court said that Seller’s fraud claim required that (1) Buyer make a material Buyer misrepresentation, (2) Buyer know that the misrepresentation was false, (3) Buyer intend to induce Seller to rely upon Buyer’s misrepresentation, (4) Seller was justified in relying upon Buyer’s misrepresentation and (5) Seller suffered damages.
Buyer contended that the allegation that it issued worthless preferred stock as part of a fraudulent scheme to induce Seller to enter into the asset purchase agreement was not economically plausible because (1) Buyer paid Seller $9.9 million cash and (2) the preferred equity was pledged to Buyer at closing to protect Buyer from the risk of Seller fraud. Therefore, Buyer argued that the fraud claim failed because Seller did not allege any misrepresentation that was material. The court agreed.
The court also held that it was unreasonable for Seller to rely on the two alleged Buyer misrepresentations.
The first misrepresentation was that Buyer expected that by the closing Buyer would have a combined $40 million in annual sales and earnings of at least $10 million a year. Seller claimed that this was a misrepresentation because actual annual sales at the time of closing were only projected to be $33 million.
First, Seller could not explain how the projections were calculated or where the numbers came from. That was because Seller conducted no projections of its own; and though Seller had the means to discover the true value of the preferred stock by the exercise of ordinary diligence; it failed to make use of those means, such as through its legal and financial advisors.
Second, the asset purchase agreement only provided for minimal Buyer warranties that Buyer would have sufficient funds to consummate the transaction and make the cash payment. And, the asset purchase agreement made clear that Seller could not rely on Buyer’s representations unless they were specifically set forth in the asset purchase agreement itself. The court noted that none of the alleged misrepresentations were covered under the asset purchase agreement.
The court also found no fraud claim against Buyer based upon the second misrepresentation. The second alleged misrepresentation, not listed in any agreement, was that Buyer had a $10 million war chest to make additional acquisitions and had secured a $3 million revolving line of credit. Seller again did not reveal any efforts on its part to confirm this information. More importantly, Seller did not disclose how this information was material to its decision to go forward with the transaction in light of the fact that, even if Buyer’s Financing Source was paid back in full by a refinancing (1) the preferred equity were transferred to Buyer as security, and (2) Seller could only demand that the preferred equity be purchased 3 years after their issuance.
To bring its point of Seller’s unreasonable reliance upon Buyer’s misrepresentations the court said that for Seller to rely on Buyer’s representations without seeing documents, which Seller claimed were material, and enter into a multi-million-dollar sale of assets cannot be justifiable. Seller never insisted on any documentation to back up the alleged misrepresentations by Buyer and Seller even signed the asset purchase agreement without insisting on access to documents such as the omitted exhibits to the agreement.
This case is referred to OmniVere, LLC v. Friedman, Case No. Docket No. 154544/2016, Motion Seq. No. 005, Supreme Court, New York County, (December 6, 2018).
Comment. The lesson for sellers when receiving equity from buyer as part of the purchase price: beware. When you are selling a company and receiving back buyer equity then you are as much a buyer as you are a seller. That means that you and your team must kick the buyer’s tires.
It also means including many more Buyer representations and warranties in the purchase agreement; meaning that the representations and warranties about buyer could be as comprehensive as Seller’s representations and warranties about the business it is selling.
By John McCauley: I help people start, grow, buy and sell their businesses.
Telephone: 714 273-6291
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