Vague APA Note Payment Adjustment Provision Results in Lawsuit

Introduction

This post closing asset deal dispute could not be resolved by summary judgment because the purchase money note adjustment provision was held to be an unenforceable agreement to agree.

The deal

The Utah based seller manufactured a garden planter product that it sold to garden stores and other consumers. After manufacturing and selling the product for some time, the seller decided to sell the manufacturing molds to the buyer, a local garden seed and supply company.

The buyer paid $100K at the August 2011 closing and delivered a $400K note payable in 8 annual installments of principal and interest beginning August 15, 2012; with the balance of principal and interest payable on August 15, 2019. The amount of the annual payment was not specified.

The note provided for reduced note payments in the in the event the planter product “failed to generate expected sales numbers in any given year” in which case “the terms of this Note shall be modified in proportion to the reduced sales numbers.”

“Expected sales numbers” was not defined. However, the seller represented the amount of its net sales for 2009 and 2010 as well as interim pre-closing numbers for 2011 in the asset purchase agreement. Also, the amount of each annual note payment was not specified.

The buyer made 4 annual note payments after the closing. In each case in disclosed how the buyer calculated the payments. The buyer used $50K as the base amount of the payment (presumable taking the $400K principal amount of the note divided by 8 annual payments). The buyer then used the last full year of pre-closing product sales (2010) as the “expected sales numbers”. The product sales for each of the first 4 years after the closing were significantly less than the 2010 product sales amount so buyer’s first 4 year note payments were significantly less than $50K.

The lawsuit

After four years of accepting the buyer’s payments, the seller sent the buyer a written notice of default claiming the buyer had failed to pay the “total amount due each year” and demanding the full balance of the loan under the note’s acceleration provision. The buyer refused saying that the amounts were in accordance with the “expected sales numbers” payment adjustment provision of the note.

The seller sued the buyer in a Utah state court. The trial court agreed with the buyer and dismissed the seller’s lawsuit and the seller appealed. The intermediate appellate court held that while the buyer and seller agreed to modify the note amounts in the event sales expectations were not met, their failure to agree on the tools to achieve that modification renders the note payment amount adjustment provision indefinite and unenforceable.

This case is referred to Bloom Master Inc. v. Bloom Master LLC.No. 20170226-CA, Court of Appeals of Utah, (Filed April 25, 2019)

Comment

The seller and buyer would have saved themselves a lot of time, money and stress by simply cleaning up the note terms. Several recommendations:

  1. State the annual interest rate;
  2. State the total amount of each annual note payment due before adjustment;
  3. State the expected sales numbers to use for the adjustment;
  4. State the formula; and
  5. Give an example.

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

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in agreement to agree is unenforceable, note payment amount adjustment, promissory note, purchase price, purchase price adjustment Tagged with: , , ,

Indiana APA Choice of Law Provision Doesn’t Apply to Its Product Line Exception

Introduction

Generally, a cash buyer of the assets of a business is not responsible for the defective products made by the seller, unless the buyer assumed those liabilities in the asset purchase agreement.

However, California started imposing the seller’s product liabilities upon certain asset buyers in 1977, and several states have followed.

The deal

This case is about a 1984 acquisition of a company that made valves. There the buyer expressly disclaimed in the asset purchase agreement any responsible for any seller liabilities.

The lawsuit

A plumber and his wife sued the buyer in a New York state court in 2014. They alleged that the plumber installed and removed seller valves, and that he may have been exposed to asbestos containing dust from gaskets, internal packing, and external insulation. The plumber alleged that due to his work asbestos-containing dust settled on his work clothing, and his wife was then exposed to this asbestos dust from washing his work clothing

The buyer and seller’s asset purchase agreement had an Indiana choice of law provision and Indiana had adopted the products line exception. Therefore, the plumber and his spouse argued that the buyer was responsible for the seller’s asbestos product liability.

The court disagreed: “This language only specifies that contractual disputes (i.e., breach of contract claims) amongst the parties to the “agreement” will be governed by Indiana law. The above language does not, however, go so far as to state that tort claims not arising directly out of the contract and the parties thereto are also governed by Indiana law.”

Instead the court applied New York law, which did not recognize the product line exception. The buyer was dismissed from the lawsuit.

This case is referred to In Re New York City Asbestos Litigation., Docket No. 190364/2014, Motion Seq. No. 005, Supreme Court, New York County, (May 20, 2019)

https://scholar.google.com/scholar_case?case=5564327915680914677&q=%22asset+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2017

Comment

A typical choice of law provision in a purchase agreement is designed to pick the applicable law for interpreting the contract; not to pick state law for resolving other disputes.

In buying the assets of a business, most states only make the buyer responsible for the liabilities of the seller that the buyer expressly assumes in the asset purchase agreement. Beyond that, the buyer needs to look at the applicable state’s successor liability law exceptions for any buyer responsibility for unassumed seller liabilities.

In many states, the successor liability law may impose seller unassumed liability on an asset buyer that pays for the business with buyer equity, in whole or part. And in a few states, including California, the successor liability law may impose seller unassumed liability on an asset buyer in an all cash deal, for seller’s product liabilities.

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

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in choice of law provision, product line exception, successor liability Tagged with: , , , , , ,

Beer Maker May Have Liability for Denying Consent to Sale of Wholesaler’s Business

Introduction

Exclusive distributor relationships with manufacturers are usually the most important assets of a distributor business. The manufacturer is usually much bigger and has most of the leverage; leading to contracts that favor the manufacturer.

Also, the manufacturer is most often not based in the distributor’s state. This has led to state laws that are designed to level the playing field in the local distributor’s dealings with the out of state manufacturer.

One of the areas that states try to help is when the distributor needs the manufacturer’s consent to sell its business to another distributor. In those circumstances states often pass laws that require the manufacturer to approve the transfer of the distributor’s contract if the buyer is qualified.

The deal

The business in this case was a Mississippi beer wholesaler. It was a wholesaler of Anheuser-Busch’s beer. Anheuser-Busch is the largest beer supplier in the country. The distributor had a longstanding position as Anheuser-Busch’s exclusive distributor for a swath of the Mississippi Gulf Coast.

In this case, the distributor entered a deal to sell its Anheuser-Busch distributorship to a nearby distributor. The distributor asked Anheuser-Busch to consent and it refused. Anheuser-Busch exercised a right under its contract with the distributor to force the distributor to sell to a different local distributor picked by Anheuser-Busch.

The lawsuit

The distributor complied but claimed it lost $3.1 million on the deal because it could not sell non-Anheuser-Busch distribution contracts to the buyer chosen by Anheuser-Busch. The loss was because the purchase price for the deal was based upon the value of each distributorship contract with each brewer, and the distributor was not able to assign non-Anheuser-Busch distributor contracts to the buyer selected by Anheuser-Busch.

The distributor accused Anheuser-Busch of refusing to approve its deal with the original buyer in violation of Mississippi law. That law says that Anheuser-Busch can’t refuse consent so long as the distributor’s proposed buyer meets “such nondiscriminatory, material and reasonable qualifications and standards required by” Anheuser-Busch for similarly situated wholesalers. Under the law, Anheuser-Busch could only refuse to approve the deal “in good faith and for good cause related to the reasonable qualifications” of the distributor’s chosen buyer.

The matter ended up in a Mississippi state court and the trial court dismissed the distributor’s claim. However, on appeal the Mississippi Supreme Court reversed, holding that the distributor had alleged facts that if true could establish that Anheuser-Busch violated Mississippi’s law when it refused to approve the distributor’s original deal.

This case is referred to Rex Distributing Company, Inc. v. Anheuser-Busch, LLC.No. 2018-IA-00037-SCT, Consolidated With No. 2018-IA-00038-SCT, Supreme Court of Mississippi, (May 23, 2019)

Comment

One of the questions a seller asks when reviewing a proposal to buy is the likelihood that the deal will close.  And one closing risk is the refusal of a required third party consent to the deal.

Required consents can be from franchisors, suppliers, distributors, intellectual property licensors, landlords, foreign, federal, state and local governments, and many others. However, there may be requirements that consents can’t be withheld unreasonably in contracts, as well as in some statutes.

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

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in asset purchase agreement, Assignment, assignment of contracts, consent to assignment Tagged with: , , , ,

Owner Sells Company’s Fitness Club Assets; Fights Personal Trainer Claims

Introduction

Selling your company can be very stressful for employees and contractors not picked up by the buyer. Especially those that have depended upon cash flow from you company for a long time.

This creates a risk you may be sued by employees or contractors left out in the cold.

The deal

This case is about a Pennsylvania based Gold’s Gym. The company operated as a corporation.

In 2014 the company sold its assets. The club had two personal trainers that had been with the club for 10 years as independent contractors under similar written agreements. Neither of these personal trainers were hired by the buyer after the closing.

The lawsuit

The two personal trainers made claims against the company amounting to $414k for breach of their contracts. They claimed that the company had promised in the contracts to assign their personal trainer contracts to the buyer.

The claims ended up in a Pennsylvania bankruptcy court. The applicable provision of the contracts were identical and said that the term of their contracts were as long as the company “remains in business, and shall be assigned by” the company “to any new owner or operator in the event of a sale, transfer or other change of control in the ownership or operation of” the company.

The trainers argued that the company had to assign their contracts to the buyer. The court disagreed saying that the company only had an obligation to assign the contracts to the buyer if there had been a stock sale, and the sale in this case was an asset sale.

This case is referred to In Re Mechanicsburg Fitness, Inc.Bankruptcy No. 1:16-bk-01897-HWV, United States Bankruptcy Court, M.D. Pennsylvania, (May 10, 2019) 

Comment

The contract language in dispute was badly drafted. I think courts could have gone either way in this case.

But one thing was clear. These personal trainers lost their living after 10 years of work at this club. Not surprising that they were motivated to salvage something from the sale.

In 20/20 hindsight, the company should have reviewed these contracts to see if the seller had any risk of post-closing liability to these trainers as a result of the termination of their contracts. A review would have led the seller to conclude that the contract language could lead to problems if these trainers were not being picked up by the buyer.

One possible solution to this problem would be for the company to try to work something out with the trainers before the closing and avoid post-closing problems.

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

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in asset purchase agreement, assignment of contracts, contracts, due diligence Tagged with:

Buyer Sues Sellers for Unjust Enrichment Based Upon Target CEO Fraud

Introduction

The seller of a business often gets the buyer to agree to limit the amount of buyer claims against the seller for breaches of the contract; whether it is an asset purchase, stock purchase, or merger agreement. And the claim limit may be substantial; even 10% or less of the transaction value.

Nevertheless, a buyer may discover after the closing that the buyer has substantially overpaid for the business because of target fraud. In such cases can the buyer recover more than the indemnification cap the buyer agreed to in the purchase or merger agreement? Sometimes.

The deal

The target in this case is an Orlando based cloud-based provider of travel distribution and passenger service system software. A buyer purchased the target in 2016 from its 100 or so shareholders for $120 million; which included a $9 million holdback, and a purchase price adjustment provision.

The lawsuit

The buyer and the target shareholders ended up in the Delaware Court of Chancery after the closing. The buyer’s claims against the shareholders included a claim that the buyer substantially overpaid for the business; well in excess of the $9 million holdback; and that the buyer was entitled to recover the amount of the overpayment from the shareholders because the overpayment was caused by the fraud of the target’s chief executive officer.

The shareholders argued that buyer’s claim should be dismissed because the buyer agreed to limit its claim to the $9 million holdback and certain purchase price adjustment claims; pointing out that the only shareholder accused of fraud was the target CEO.

The target shareholders argued that the buyer’s unjust enrichment claim should be dismissed because the buyer seeks to hold the target shareholders personally liable for the target CEO’s alleged wrongs. The court rejected that argument saying that a Delaware unjust enrichment claim is permitted even when the target shareholders, who retain the benefit, are not wrongdoers.

Why? To deprive the target shareholders of benefits that in equity and good conscience the target shareholders ought not to keep, even though the target shareholders may have received those benefits honestly in the first instance.

 

This case is referred to Shareholder Representative Services LLC v. RSI Holdco, LLCC.A. No. 2018-0517-KSJM, Court of Chancery of Delaware, (Decided: May 22, 2019)

 

Comment

It can be very difficult for a buyer that feels it has substantially overpaid for a company because of fraud to overcome the indemnity cap contained in the M&A documents. Under Delaware law, if the merger agreement comprehensively governs the target shareholders and buyer’s relationship, then the merger agreement (along with the indemnification cap) must provide the measure of the buyer’s rights and any claim of unjust enrichment will be denied.

But the merger agreement itself is not necessarily the measure of the buyer’s right where the claim is premised on an allegation that the merger agreement arose from the target CEO’s fraud and the target shareholders have been unjustly enriched by the benefits flowing from the merger agreement.

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

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in fraud, rescission, unjust enrichment Tagged with: , , , ,

Asset Buyer Fights Customer Claim Based Upon Unassumed Seller Contract

Introduction

A buyer and seller agree to a price for the sale of the seller’s company. Then the buyer gets his or her adviser involved to iron out the details.

One of those details is whether the transaction will be a sale of the assets of the target or a sale of the target itself (for example the sale of stock if the target is a corporation).  Does it matter?

Well, there may be contracts the target has with customers, suppliers, employees, lenders and investors. The adviser explains that if the buyer purchases target assets, the buyer can pick and choose which contracts the buyer wants to buy or assume.

There may be some contracts that the buyer does not want. For example, the buyer may not like the terms that the target has with a major customer; and so, in an asset deal the buyer would not buy or assume that customer contract; and try to cut a new deal with the customer if the buyer can.

In contrast in a stock deal, the buyer inherits all the target’s contracts because it bought the company, not some of the target’s assets.

So, does the asset buyer have any risk under the unassumed customer contract after the asset deal closes? Usually not; but there are exceptions.

The deal

Our buyer bought the assets of a North Dakota based oil and gas drilling machinery company in 2011. One of the assets was a 2010 contract seller had with its largest customer. The customer contract with the seller stated that the seller could not assign the contract to the buyer without the customer’s consent.

Nevertheless, the seller had agreed that if consent was not obtained it would work with the buyer after the closing to permit the buyer to keep the customer’s business; even if the seller had to use the buyer to service the customer through a subcontract.

In the end, the buyer did not obtain the customer’s consent but continued to service the customer without the help of the seller; but using the seller’s tradename in its dealings with the customer; which it had purchased in the deal.

The lawsuit

In 2012, one of the buyer’s employees was injured while performing work for the customer. The employee’s right to compensation from the buyer was limited by North Dakota’s worker’s compensation laws.

The injured employee therefore sued the customer for negligence. The customer turned around and sued the buyer for indemnification. The customer claimed that the seller had agreed to indemnify the customer for this accident under their 2010 contract; and that the buyer had assumed seller’s indemnification obligation.

The buyer claimed that it was not responsible to the customer because the buyer did not assume the 2010 contract that the seller had with the customer; and especially because the customer had not consented to the assignment.

The customer said that it consented after the lawsuit and that was good enough; especially because the buyer continued to service the customer after the closing using the seller’s trade name.

The court held that this dispute could not be decided at this preliminary stage of the litigation. Meaning, that the buyer ultimately may have to indemnify the customer.

This case is referred to Peterson v. Murex Petroleum Corporation, Case No. 1:17-cv-165, United States District Court, D. North Dakota, (April 25, 2019)

Comment

The takeaway here is that an asset buyer may be stuck with a seller’s contract even if consent is required by the other party to the contract; and not given. In this case, it may turn out that the buyer’s post-closing conduct of servicing the customer under the seller’s tradename; and perhaps the customer’s acceptance of those services established a legal assignment of the contract.

But what could have the buyer done to avoid this litigation with 20/20 hindsight? Well the buyer could have negotiated a new contract with the customer that would have yielded a more favorable indemnification provision.

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

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in asset purchase agreement, assignment of contracts, assumed liabilities, assumption of a contract, consent to assignment, due diligence Tagged with: , , ,

Seller Argues That Indemnification Cap Applies to Excluded Liabilities

Introduction

An advantage of an asset sale is that a buyer can pick and choose which seller liabilities the buyer wants to be responsible for under the asset purchase agreement; often referred to as the assumed liabilities.

However, the buyer may have to deal with unassumed seller liabilities (often referred to as excluded liabilities or retained liabilities). There are several reasons for this. In some cases, the excluded seller liability is owed to a valuable customer that the buyer wants to keep happy. Or the buyer may get stuck with a seller liability under federal or state law even if the buyer did not assume the seller liability in the asset purchase agreement; this type of liability inventory was “usable and salable in the ordinary course of business (often called successor liability).

In either case, the buyer often requires the seller to promise in the asset purchase agreement to indemnify the buyer for paying off these seller liabilities.

The deal

Our seller was an Akron based private equity firm specializing in investments in distressed or underperforming middle market and mature companies. Through subsidiaries, it owned and operated a chemical division that chiefly sold research and development services to biotech, pharmaceutical, food, flavor, fragrance and specialty chemical customers.

The seller sold the chemical division to the buyer for $27 million; and an opportunity for an earnout of $5.5 million if the business hit an earnings target for the first year after the closing.

The lawsuit

The buyer had a post-sale contract dispute with a seller customer arising from allegedly contaminated chemical inventory the buyer acquired from the seller. Buyer subsequently agreed to settle this dispute for $2.25 million.

The seller refused to indemnify the buyer for the $2.25 million loss. They wound up in an Ohio federal district court.

The seller argued that the buyer’s indemnification claims had already exceeded the asset purchase agreement’s indemnification cap of 10% of the purchase price. The seller said that the buyer was accusing it of breaching seller’s asset purchase agreement representation and warranty that the seller inventory was “usable and salable in the ordinary course of business.” The seller pointed out that the indemnification cap applied to all its breaches of representations and warranties and that buyer’s representation and warranties indemnification claims had already exceeded the cap.

The buyer pushed back saying that the seller was responsible for the buyer’s $2.25 loss even if the buyer’s loss arose from a seller representation and warranty breach. That is because the indemnification cap did not apply to the seller’s asset purchase agreement promise to indemnify the buyer for any loss the buyer suffered from the seller’s excluded or retained liabilities; or a buyer loss arising out of the operation of the chemical division by the seller before the closing.

The court held that the indemnification cap provision could be read either way and so the dispute must go to trial and not be disposed of in this preliminary proceeding.

This case is referred to Main Market Partners, LLC v. Olon Ricerca Bioscience LLC, Case No. 1:18-CV-916, United States District Court, N.D. Ohio, (April 9, 2019)  https://scholar.google.com/scholar_case?case=4976259500205573361&q=%22asset+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2017#r[17]

Comment

Frankly, the buyer seems to have the much better argument. I suspect that it will be decided by the court or jury that the intent was to limit the indemnification cap to a breach of reps and warranties only. That means that the cap does not apply to a seller breach of any of its other seller promises made in the asset purchase agreement.

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

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in asset purchase agreement, excluded or retained liabilites, indemnification cap, post closing covenants Tagged with: , , , ,

Business Buyer and Seller Battle over Indemnification Cap Language

Introduction

Over the years sellers of businesses have often been able to limit their risk of post-closing indemnification claims from the buyer using indemnification caps, deductibles and threshold provisions in purchase agreements.

It is quite common for a buyer to agree to cap the amount of damages it can recover from the seller for the seller’s breach of a purchase agreement.

The deal

Our seller was an Akron based private equity firm specializing in investments in distressed or underperforming middle market and mature companies. Through subsidiaries, it owned and operated a chemical division that chiefly sold research and development services to biotech, pharmaceutical, food, flavor, fragrance and specialty chemical customers.

The seller sold the chemical division to the buyer for $27 million; consisting of $8.4 million payable in cash to the seller at closing and an assumption of $18.6 million of seller debt. The buyer also agreed to pay the seller an earnout of $5.5 million if the business hit an earnings target for the first year after the closing.

The lawsuit

The buyer and seller’s relationship soured after the closing. The buyer was disappointed with the post-closing performance of the chemical division and the seller did not receive its earnout. They ended up in an Ohio federal district court.

The buyer accused the seller of understating the costs of the business by almost $2 million. Specifically, the seller had represented and warranted that the 2016 business costs were as stated in a schedule attached to the asset purchase agreement. The $27 million purchase price would probably be too high if the chemical division’s 2016 costs were understated by $2 million; given the chemical division’s value was probably based at least in part on a multiple of earnings.

The buyer’s claim then led to a dispute over the amount of the indemnification cap. In other words, what is the seller’s maximum exposure to the buyer for understating the costs of the business?

The indemnification cap provision in the asset purchase agreement capped the seller’s liability for a breach of its representation and warranties to 10% of the “aggregate purchase price actually paid” by the buyer to the seller. The buyer argued that the cap was $2.7 million; arguing that the “aggregate purchase price” was $27 million. The seller disagreed and said that the cap was $840K which is 10% of the $8.4 million aggregate purchase price “actually paid” to the seller; not including the $18.6 million seller debt assumed by the buyer.

The court held that the provision could be read either way and so the dispute must go to trial and not be disposed of in this preliminary proceeding.

This case is referred to Main Market Partners, LLC v. Olon Ricerca Bioscience LLC, Case No. 1:18-CV-916, United States District Court, N.D. Ohio, (April 9, 2019)  https://scholar.google.com/scholar_case?case=4976259500205573361&q=%22asset+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2017#r[17]

Comment

Indemnification provisions are part of the “boilerplate”. But they are often the first thing that the buyer and seller lawyers look for in the purchase agreement when a post-closing fight breaks out. They are often the first thing that a seller lawyer looks for when reviewing the buyer’ lawyer’s first draft of the purchase agreement.

In 20/20 hindsight, the buyer and seller should have tightened up the cap language. How? One way would be keep it simple and cap it at a specific amount such as $2.7 million.

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

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in indemnification cap, percentage of purchase price Tagged with: , ,

Buyer of Chemical Division Sues Seller for Understating Costs

Introduction

There are unique risks for a buyer when purchasing a division of a seller (called a divestiture). It is easier to assess the quality of earnings of a stand alone business than with a division where costs must be allocated to the division from the rest of the company.

The deal

Our seller was an Akron based private equity firm specializing in investments in distressed or underperforming middle market and mature companies. Through subsidiaries, it owned and operated a chemical division that chiefly sold research and development services to biotech, pharmaceutical, food, flavor, fragrance and specialty chemical customers.

The seller sold the chemical division to the buyer for $27 million. The buyer also agreed to pay the seller an earnout of $5.5 million if the business hit an earnings target for the first year after the closing.

The lawsuit

The buyer and seller’s relationship soured after the closing. The buyer was disappointed with the post-closing performance of the chemical division and the seller did not receive its earnout. They ended up in an Ohio federal district court.

The buyer accused the seller of understating the costs of the business. Specifically, the seller had represented and warranted that the 2016 business costs were as stated in a schedule attached to the asset purchase agreement.

The alleged understated costs related to seller’s allocation of companywide costs. There were two categories of disputed costs. One was administrative costs which were primarily, salary and benefits for sixteen employees working in human resources, finance and IT. The buyer said those costs should have been allocated by employee head count. They were not.

The second cost category was support group (quality assurance and product management). The buyer claimed that these costs should have been allocated by revenue. They were not.

The buyer stated that the seller used the headcount and revenue methods in its internal financials to allocate administrative and support group costs to the chemical division before the sale, and that the total of these 2016 costs allocated to the division in the internal financials totaled $2.3 million; not the $500K the seller represented and warranted were these costs in its representations and warranties. The buyer accused the seller of intentionally downplaying the chemical division costs to make the chemical division appear more profitable than it was.

The buyer asked the court to rule that the seller breached its representations and warranties in connection with the 2016 costs.

The seller denied that it misrepresented the costs of the chemical division. It argued that the costs represented in the agreement were not inaccurate because they were “pro forma” income statements. That is, the figures represent the hypothetical costs of the chemical division operated as a standalone company, not the actual costs incurred as a division of the seller. And because the assumptions and projections used to arrive at these pro forma estimates were detailed in the confidential offering memorandum, given to the buyer, the seller argued that the financial representations were sufficiently accurate and reasonable.

The court refused to rule that the seller understated costs at this stage of the litigation, saying that there is a material fact dispute regarding the buyer’s claim. On one hand, the seller stated that the figures represent all or substantially all the cost items of the business for the 12-month period ending December 31, 2016, suggesting that the schedule was meant to represent the chemical division’s actual 2016 costs. On the other hand, the schedule was labeled “Pro Forma FY 2018 income statement” and was described as “estimates” in the offering memorandum. Viewed in the light most favorable to the seller, this labeling sufficiently raises issues whether the seller’s representations were false.

The result is that the litigation goes beyond this preliminary legal skirmish.

This case is referred to Main Market Partners, LLC v. Olon Ricerca Bioscience LLC, Case No. 1:18-CV-916, United States District Court, N.D. Ohio, (April 9, 2019)  https://scholar.google.com/scholar_case?case=4976259500205573361&q=%22asset+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2017#r[17]

Comment

Could the buyer have discovered the historical cost allocation for the business before signing the asset purchase agreement through due diligence, such as through a quality of earnings assessment?

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

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in divestitures, due diligence, quality of earnings assessment Tagged with: , ,

Business Seller Accuses Buyer of Earnout Manipulation

Introduction

A seller of a business wants to receive the highest price, and payable in cash at closing. The buyer might want to pay seller’s price but is not sure it is worth that much. How do you bridge the gap?

This can be done by making some of the purchase price based upon the post-closing performance of the business. An example would be the EBITDA performance of the business over the first year after the closing. This payment structure is often called an earnout or earn-out.

The seller may think that the business can perform well enough to trigger the earnout. But will it under the buyer’s management? Is buyer capable of operating the business well enough? More cynically, would the buyer play games with expenses and revenue over the earnout period to avoid triggering the earnout payment?

The deal

Our seller was an Akron based private equity firm specializing in investments in distressed or underperforming middle market and mature companies. Through subsidiaries, it owned and operated a chemical division that chiefly sold research and development services to biotech, pharmaceutical, food, flavor, fragrance and specialty chemical customers.

The seller sold the chemical division to the buyer, a subsidiary of an Italian chemical firm for $8.4 million in cash at closing and assumption of $18.6 million of seller debt. The buyer also agreed to pay the seller an earnout of $5.5 million if the chemical division hit an EBITDA earnings target for the first year post sale year. The buyer promised the seller in the asset purchase agreement to refrain from taking any bad-faith actions to avoid the earnout payment.

The lawsuit

The business did not meet its earnings target and no earnout was paid to the seller. The seller sued the buyer in an Ohio federal district court for allegedly manipulating its earnings and revenue to avoid hitting the earning target.

The buyer claimed that seller’s allegations, if true, did not amount to buyer’s breach of its promise to refrain from taking bad-faith actions to avoid the earnout payment.

The court disagreed. The court said that these seller allegations could establish bad faith. The seller accused the buyer of: (1) steering the chemical division business to the buyer’s Italian parent company, (2) delaying the receipt of customer payments;  (3) incurring $3 million in unreasonable strategic costs during the earnout period; (4) failing to contemporaneously track and account for strategic costs; and 5) obscuring and concealing strategic costs.

The result? The seller gets to push forward in its litigation.

This case is referred to Main Market Partners, LLC v. Olon Ricerca Bioscience LLC, Case No. 1:18-CV-916, United States District Court, N.D. Ohio, (April 9, 2019)  https://scholar.google.com/scholar_case?case=4976259500205573361&q=%22asset+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2017#r[17]

Comment

Earnout deals come with risk because the seller loses control of the business. Always best to at least consider taking a lesser amount at closing than agreeing to a larger amount payable after the closing that is dependent upon the buyer.

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

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in bad faith, earn outs Tagged with: , , ,

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