No Seller Indemnification Obligation to Buyer for Recall of Pre-Closing Product

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December 19, 2019

Introduction

The buyer of a manufacturing company runs the risk of having to repair or replace a product made by the seller before the closing. One risk is the cost of a recall of a product line to deal with a significant design flaw.

The deal

The seller in this deal made recreational boats. It sold three brands of its bass fishing boats to a national outdoor recreational equipment retailer, for $260 million. $2.6 million of the purchase price was placed in escrow to secure the seller’s indemnification obligations under the Membership Interest Purchase Agreement. The escrow funds not required by indemnification had to be released to the seller by the first anniversary of the closing.

The lawsuit

After the sale, the buyer discovered that several purchasers of a particular line of boats included in the sale had presented warranty claims to the seller after noticing that the hulls of the boats had cracked or delaminated. The seller did not disclose the warranty claims or increase its warranty reserve in the financial statements provided to the buyer in connection with the purchase agreement.

The buyer determined the cracks and delamination in the hulls resulted from the seller having manufactured the boat hull with fewer layers of laminate than was called for in the boat’s design. The buyer also concluded that this production flaw affected an entire production run of boats and, therefore, case-by-case repairs would be inadequate to solve the problem. Instead, the buyer elected to replace the hulls of every boat produced with the allegedly defective hull. This decision prompted the buyer to initiate a “Replacement Program” whereby it recalled and replaced the hulls of every affected boat at an estimated total cost of $5 million.

The buyer notified the seller before the expiration of the one year escrow expiration period of a claim for indemnification under the purchase agreement, asserting that the seller’s failure to disclose the manufacturing defect and account for it in its financial statements breached certain of the purchase agreement’s representations and warranties. The buyer stated that its expected damages caused by the breach were $5 million.

The seller did not agree and after expiration of the one year escrow period demanded that the buyer consent to release the $2.6 million escrow fund. The seller refused and the dispute ended up in the Delaware Court of Chancery.

After trial the court concluded that the buyer had not proved that a product recall was not justified, because the problem could be solved by a much less costly repair or replacement of defective hulls on a case by case basis. Furthermore, the court found that the seller did not breach its financial, undisclosed or MAE rep, because the problem was not material. And although the seller breached a rep by not disclosing, the warranty claims, it was “no harm, no foul” because the seller’s reserve in its financial statements were more than adequate to cover the known claims.

The result? The court ordered the buyer to consent to the release of the escrow funds.

This case is referred to as Project Boat Holdings, LLC v. Bass Pro Group, LLC, C.A. No. 2018-0429-KSJM, Court of Chancery of Delaware (Decided: May 29, 2019. Revised: June 4, 2019)  

Comment

We don’t know whether the buyer asked a law firm experienced in post-closing M&A disputes, what the chances were that the buyer could recover the costs of the $5 million recall from the seller.

Also, we don’t know whether the buyer tried to include a provision in the purchase agreement obligating the seller to indemnify the buyer for any buyer loss arising out of any boats produced by the seller before the closing. That provision would have given the buyer more time to assess its exposure for the defective hulls; provided that the escrow agreement said that giving notice of product defects would extend the escrow period for an additional agreed term.

This additional language would have avoided all the fight about whether the seller breached its financial, undisclosed liability, MAE and warranty rep. Also, this provision is not breached until a claim is made and so does not accrue until then, not at closing.

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

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Posted in breach of representations and warranties, financial representation and warranty, indemnification, indemnification for pre-closing product loss, MAE rep, No Undisclosed Liabilities, representations and warranties

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