This opinion from the Delaware Court of Chancery addresses claims involving a post-closing purchase price adjustment in an M&A transaction. The lessons of this case are plain: buyers and their advisors need to pay careful attention to the working capital adjustment provisions in the purchase agreement, including sample working capital calculations and agreed-upon accounting procedures, to ensure they are comprehensive and leave room for adjustment if certain liabilities that should have been included are inadvertently omitted because the Delaware courts will strictly enforce the agreement as written. Likewise, without negotiating for robust post-closing indemnification obligations from the sellers (and not just the target company) in a stock purchase transaction, buyers will have very limited recourse should they uncover problems with the target’s financial statements post-closing.
In December 2018, the buyer, a theatrical production and distribution company, agreed to purchase the target company, a theater chain dedicated to independent cinema, via a stock purchase for a purchase price of $148.8 million, subject to certain “true-up” adjustments at closing and post-closing based on the target company’s closing net working capital, indebtedness, cash, and transaction expenses. The purchase agreement provided that, at closing, the buyer would place $3 million of the purchase price into escrow to cover any downward adjustment to the purchase price.
The mechanics of the purchase price adjustment will be familiar to those involved in middle-market, private company M&A. At closing, the target company delivered a preliminary closing statement to the buyer containing estimates of the target company’s net working capital, indebtedness, cash, and transaction expenses as of the closing. Those amounts were calculated in accordance with certain agreed-upon procedures set forth in an exhibit to the purchase agreement, including a sample working capital calculation statement. After closing, the buyer had a certain period of time to perform its own calculation of the closing net working capital, indebtedness, cash, and transaction expenses, and deliver a final closing statement to the sellers (using the same agreed-upon procedures). The purchase agreement provided for a post-closing true-up of the purchase price to account for any variances between the target company’s estimates in the preliminary closing statement and the buyer’s calculations in the final closing statement. The purchase agreement further provided that any disputes among the parties regarding the calculation of the post-closing purchase price adjustment would be referred to an independent accounting firm, whose decision would be binding on the parties.
After the parties were unable to resolve certain disputes regarding the purchase price adjustment, they engaged PwC to serve as the independent accountant. PwC resolved each of the disputed items in the sellers’ favor with the exception of the target company’s closing cash balance. The sellers then requested that the buyer instruct the escrow agent to release the escrowed funds pursuant to PwC’s determination, but the buyer refused, prompting this action.
The sellers filed suit in July 2019 seeking an order of specific performance requiring the buyer to release the escrowed funds (plus expenses, as provided in the purchase agreement). The buyer countersued, arguing that PwC’s determinations were not binding because the sellers had breached the purchase agreement and engaged in bad faith and fraud in preparing certain interim financial statements of the target company delivered pursuant to the purchase agreement. The specific areas of dispute related to whether the target company had made an appropriate reserve against an account receivable balance from a third party known to be in financial distress, whether the target company had appropriately recorded outstanding checks, and the target company’s alleged failure to disclose and record certain management bonus liabilities, medical claim liabilities, and miscellaneous liabilities in its financial statements.
It is worth noting that this particular purchase agreement provided that the representations, warranties, and covenants of the parties terminated at closing and that no party would have any recourse against another for breach of a representation, warranty, or covenant following the closing, which is somewhat uncommon for a transaction of this size. The purchase agreement did not give the buyer the right to seek indemnification from the sellers for breaching representations and warranties. Instead, the buyer alleged that the sellers breached various provisions of the purchase agreement, breached the implied covenant of good faith and fair dealing, and committed fraud and fraudulent concealment. The buyer’s specific allegations were that (i) the sellers were liable for the target company’s breach of the obligation to provide good faith estimates in the preliminary closing statement, (ii) the sellers breached the following condition to closing under the purchase agreement—that the sellers shall have performed all obligations and agreements and complied with all covenants and conditions required by the purchase agreement to be performed or complied with by them prior to or at the closing—which the buyer argued implied a “promise that accurate disclosures in good faith would occur,” (iii) the sellers breached the implied covenant of good faith and fair dealing in connection with the preparation of the preliminary closing statement and the interim financial statements on which they were based, and (iv) the sellers committed fraud and fraudulent concealment in their treatment of the accounts receivable balance, outstanding checks, management bonus liabilities, medical claim liabilities, and miscellaneous liabilities in the target company’s financial statements.
The Court’s Analysis of the Breach of Contract Claims
The Delaware Court of Chancery rejected claims (i), (ii), and (iii), concluding that they were improper attempts to circumvent the clear contractual limitations in the purchase agreement that effectively barred a direct claim for breach of the target company’s financial representations and warranties. “Having agreed to those terms, Buyer cannot create new free-floating contractual protections that it did not bargain for through an unrelated provision of the Purchase Agreement,” the court explained. As to the first claim, the court noted that under the purchase agreement, it was the target company’s obligation, rather than the sellers’ (the target company’s stockholders’) obligation, to prepare and deliver the preliminary closing statement. The court held that the buyer could not hold the sellers liable for a contractual obligation of the target company, explaining that the parties were not interchangeable (and a claim against the target company would be worthless to the buyer, since it now owned the target company). The court similarly rejected the second claim, explaining that the provision was merely a condition to closing (and so if the buyer had uncovered a breach of a representation, warranty, or covenant of the sellers or target company prior to closing, it could have refused to close), and not a separate representation or warranty from the sellers regarding the accuracy of the target company’s financial statements. The court likewise rejected the third claim, noting among other things that the specific financial items in dispute had been submitted to PwC in accordance with the purchase agreement and resolved in the manner specified in the purchase agreement, and that there was no gap in the contract or unanticipated development requiring the application of the implied covenant of good faith and fair dealing.
The Court’s Analysis of the Fraud Claims
The court permitted certain of the buyer’s fraud claims to survive, denying the sellers’ motion to dismiss. Explaining the relevant legal standard, the court noted that:
[I]t is relatively easy to plead a particularized claim of fraud based on a written representation in a contract, because the allegedly false contractual representation satisfies much of the requirement to plead a claim of fraud with particularity. … The only remaining allegations necessary are facts sufficient to support a reasonable inference that the representations were knowingly false. (Citations and internal quotation marks omitted.)
The court noted that under the purchase agreement, the buyer had acknowledged that it was not relying on any statements except the representations and warranties of the sellers and target company expressly contained in the purchase agreement. The court pointed out that the purchase agreement included a representation and warranty from the target company that its financial statements fairly presented the target company’s financial condition and operating results in all material respects. The court also pointed to Delaware case law confirming that the sellers could be held liable for misstatements by the target company where the sellers are alleged to have acted through the target company. Here, the sellers’ CFO was also the CFO of the target company and was responsible for preparing the interim financial statements and preliminary closing statement.
The court then analyzed each of the specific fraud claims alleged by the buyer. With respect to the reserve for the distressed account receivable, the court dismissed the claim, finding that the buyer failed to make particularized allegations that the sellers knew the receivable would be uncollectible (the buyer and seller simply disagreed on the size of the appropriate reserve). The court dismissed fraud claims relating to certain other miscellaneous liabilities on similar grounds. However, the court permitted fraud claims based on allegations that the target company’s interim financial statements wrongfully excluded planned merit increases and incentive bonuses for the target company’s management based on defined performance targets, and similarly excluded certain known medical claim liabilities. The court concluded that these liabilities were “knowable,” due to the joint role of the sellers’ CFO as the CFO of the target company and the magnitude (more than $1 million) of these liabilities.
Finally, the court dismissed fraud claims based on the preliminary closing statement. Noting that the treatment of the target company’s outstanding checks was the only issue unique to the preliminary closing statement not already addressed elsewhere in the opinion, the court proceeded to dismiss this claim because the purchase agreement required the target company’s net working capital to be determined by reference only to those accounts referenced in the sample working capital statement attached as an exhibit to the purchase agreement, which did not include the accounts at issue in this claim.
The decision reaffirms the Delaware courts’ contractarian approach to M&A disputes. Here, the buyer did not negotiate for and obtain customary post-closing indemnities from the sellers for breaches of the target company’s representations, warranties, and covenants. It was therefore left with only the ability to bring fraud claims for alleged material misstatements and omissions in the target company’s financial statements—which, given the high pleading standard for fraud claims under Delaware law, is a very limited remedy. This case also instructs that when dealing with allegations of accounting fraud in connection with an M&A transaction governed by Delaware law, common law fraud claims typically only provide a remedy for what may be viewed as more egregious misconduct (such as the complete failure to record a liability) rather than more commonplace financial statement issues (disagreement over the size of a reserve for bad debts), even if equally material in size.