Explore a legal analysis of a significant M&A case where a buyer’s claim for indemnification in a product recall dispute was examined by the Delaware Court of Chancery. Gain insights into the court’s verdict and learn how such disputes can be mitigated in M&A deals.
December 19, 2019
Introduction:
When a buyer acquires a manufacturing company, there’s a potential risk of dealing with product issues from the seller’s side before the acquisition. One such risk is the expense of recalling a product due to significant product flaws that become apparent after the deal is sealed.
The Scenario:
In this specific case, the seller was a company that manufactured recreational boats. They sold three brands of bass fishing boats to a national outdoor equipment retailer for $260 million. As part of the agreement, $2.6 million was held in escrow to cover the seller’s obligations for indemnification as outlined in the Membership Interest Purchase Agreement. Any unused escrow funds were to be returned to the seller within a year of the closing.
The Challenge:
After the sale, the buyer discovered that certain boats from the seller’s product line had experienced hull cracks and delamination issues. Buyers who had purchased these boats had filed warranty claims due to these defects. Notably, the seller had not disclosed these warranty claims or adjusted its financial statements to account for them in connection with the purchase agreement.
The buyer investigated and found that the problems stemmed from the seller’s manufacturing process, where they used fewer layers of laminate than the boat design required. This flaw affected an entire batch of boats, making case-by-case repairs insufficient. The buyer decided to initiate a “Replacement Program,” recalling and replacing the hulls of all affected boats, totaling an estimated cost of $5 million.
Legal Proceedings:
Before the escrow expiration, the buyer informed the seller of a claim for indemnification, citing the breach of certain representations and warranties in the purchase agreement. The buyer asserted that the failure to disclose the manufacturing defect and its impact on financial statements had caused damages amounting to $5 million.
The seller disagreed and, after the escrow period ended, demanded the release of the $2.6 million escrow fund. With both parties unable to reach an agreement, the case was taken to the Delaware Court of Chancery.
Court Verdict:
Following the trial, the court concluded that the buyer had not sufficiently demonstrated the need for a product recall. The court believed that a more cost-effective solution was available through case-by-case repairs or replacements for the defective hulls. Additionally, the court found that the breach of warranties was not significant as the issue was not deemed material. Despite the seller’s failure to disclose warranty claims, the court deemed it inconsequential as the seller’s financial reserves were more than enough to cover the known claims.
The Outcome:
Consequently, the court ruled in favor of the seller, instructing the buyer to consent to the release of the escrow funds.
Comment:
This situation could have been avoided if the purchase agreement included a provision where the seller committed to indemnify the buyer against losses arising from any pre-closing product issues. This would have eliminated a dispute over materiality of the breach of representations and warranties.
Case Reference:
This case is referred to as Project Boat Holdings, LLC v. Bass Pro Group, LLC, C.A. No. 12606-VCS., Court of Chancery of Delaware (Decided: May 29, 2019. Revised: June 4, 2019)
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).
Email: jmccauley@mk-law.com
Profile: http://www.martindale.com/John-B-McCauley/176725-lawyer.htm
Telephone: 714 273-6291
Check out my book: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles
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