Trust but Verify-Business Seller Failed to Verify Accuracy of Earnout Statement

Introduction

A buyer and seller of a business often use an earnout when they can’t agree upon a purchase price. In that case, the purchase agreement provides for a buyer calculation of the earnout amount, along with an earnout dispute resolution procedure; which gives the seller the right to verify and challenge the accuracy of the earnout calculation.

In this case the seller did not verify or challenge the accuracy of buyer’s earnout calculation; and  lost the right to a potential earnout.

The deal

The Texas based seller was in a business that provided environmental management services to the oil and gas industry. Pursuant to an asset purchase agreement, or APA, the seller sold the business assets to the buyer in 2015 for a fixed purchase price plus an earnout based upon the earnings of the business for the calendar years ending 2016, 2017, and 2018.

The lawsuit

In accordance with the terms of the APA, the buyer delivered the 2016 and 2017 earnout statements to the seller. The 2016 and 2017 earnout statements represented that the business generated a loss and, consequently, no earnout payment was due in those years. The seller did not review the materials used in preparing the 2016 and 2017 earnout statements, nor did the seller challenge the accuracy of the 2016 and 2017 earnout statements within the thirty-day window for delivering an earnout dispute notice, in accordance with the APA.

After receiving more data related to the 2018 earnout statement, the seller began to suspect that there were material misrepresentations or miscalculations in the 2016 and 2017 earnout statements. The seller in November 2018 made a formal written request for the underlying documentation forming the basis of the 2016 and 2017 earnout statements, but the buyer declined to provide the documentation.

The seller sued the buyer and the dispute ended up in a Delaware federal district court.

The seller accused the buyer of manufacturing losses by diverting business earnings to other buyer companies and charging improper expenses to the business. However, the seller had to base its claims on fraud (a tort remedy) instead of relying upon the APA’s contract remedy because the seller had not followed the APA’s earnout dispute resolution procedures.

The buyer asked the court to dismiss the seller’s complaint because the seller had no right to sue the buyer for fraud. The U.S. magistrate agreed with the buyer and has recommended that the Delaware federal district court dismiss the seller’s lawsuit, with prejudice.

The magistrate held that the seller’s claim for fraud falls because the seller had the right under the APA to inspect the books and records of the business to verify the accuracy of buyer’s calculations; and if timely disputed, cause the earnings calculation to be made by an independent accounting firm; but the seller failed to do so.

This case is referred to Richie v. Hillstone Environmental Partners, LLC, Civil Action No. 19-649-RGA-SRF, United States District Court, D. Delaware, (July 9, 2019)

Comment

The magistrate also rejected the seller’s claim for fraud based upon the economic loss doctrine, which generally prohibits recovery against the buyer by a seller of a business in tort for economic harm. The purpose of the economic loss doctrine is to prevent tort law from reallocating risks between the buyer and the seller who fairly have negotiated an arms-length asset purchase agreement.

In the present case, the federal magistrate noted that the seller sought the recovery of monetary damages mirroring the relief permitted under the APA; which required the buyer to compensate the seller for any inaccuracies in the earnout statements in accordance with the determination by an independent accounting firm. Thus, the magistrate concluded that the economic loss doctrine also prevented the seller from suing for fraud.

The magistrate also rejected the buyer’s attempt to come within the fraud in the inducement exception to the economic loss doctrine because although fraudulent inducement is a recognized exception to the economic loss doctrine, the exception does not apply where, as here, the fraud claim relates to the buyer’s performance under the APA, as opposed to buyer committing fraud upon the seller to induce the seller to enter into the asset purchase agreement in the first place.

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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