So The Business You Bought Is Not What You Thought… Now What?

Thursday, 23 October 2014 14:33 Written by  Thomas P. Donnelly

My wife doesn’t eat fish.  Chicken is the staple of the diet in our house.  Despite careful consideration, sometimes she gets tricked into consuming what looks like a tasty morsel only to be disappointed by the taste and texture of what comes from the sea.  She promptly, but of course gracefully, extracts the fishy culprit from her mouth thereby rescinding the transaction and restoring her being to non-seafood status.  Of course, a fishy business transaction cannot be so easily unwound.

Business transactions come in all shapes and sizes.  From multi-million dollar mergers involving teams of lawyers and accountants to small asset purchases effectuated by only a bill of sale scribbled on a napkin.  Most fall somewhere in between.  Almost all involve disclosure of financial and business information in advance of closing in a “due diligence” period of evaluation and investigation.  Due diligence is the means by which a buyer attempts to verify what the seller has to sell; the ongoing revenue stream and the customer pipeline.  Sometimes the performance of the business after closing sharply contrasts the results of operations depicted in financial information exchanged in due diligence.  The new owners are left without a roadmap to ascertain the disparities in performance.  The investigation can be all consuming and require substantial attention and money at a time when the business is already in a period of transition.  The new owners must balance examination of the transaction and results of operations against the focus required to conduct the daily activities of the business which, of course, remain pressing and are likely made more complex by the unexpected performance levels. 

Hopefully, any agreements reached between the parties contain representations and warranties which could benefit the purchaser.  The terms of the agreement are the best place to start the analysis of potential legal action.  Generally, such agreements will represent and warrant the financial information exchanged in due diligence was accurate and adequately described the performance of the business. For example, often tax returns, profit and loss statements and balance sheets will be exchanged in due diligence and subject to specific representations and warranties.  Examination of what documents were specifically referenced as included in the representations and warranties is critical. Where the prevailing agreements contain integration clauses, the representations and warranties are of paramount importance as integration clauses can prohibit reliance upon statements and information not specifically incorporated into the four corners of the documents and bar claims such as negligent misrepresentation and, potentially, fraud. 

Determining whether the profit and loss statements and balance sheets contain material mis-statements of operations can be complicated.  The investigation must begin with securing all documents subject to due diligence and the verification that those documents were the same documents that were prepared in the ordinary course of business.  Ensure that any financial records or tax returns produced by the seller match financial records available from a different source such as a broker, accountant or internal revenue service.  Of course, information becomes more available after the commencement of litigation by virtue of the discovery process.

The forensic analysis involves testing the information set forth in summary form in the financial statements against whatever other information is available.  Quickbooks reports can reveal adjustments made to performance results.  The reality however, is that most business owners, and for that matter attorneys, lack the requisite expertise to effectively conduct the necessary investigation.  Accordingly, a forensic accountant skilled in fraud examination and detection is a valuable member of the analytical team.  Certainly, there is a cost associated with that service, which cost must be incurred before the results are clear, but the expertise of the investigation will often control the outcome.  The forensic accountant is trained to identify inconsistencies such as whether payroll was accurately stated, whether inventory and costs of goods sold were appropriately booked and whether income as stated on the financial records is impacted by other unspecified factors.  A preliminary forensic investigation is essential to the decision to pursue costly litigation.

A buyer must also consider the potential parties, their financial positions, and the types of claims that can be raised.  In seller financed transactions, as opposed to bank financed transactions, the buyer’s leverage is significantly enhanced.  In the former, the buyer may apply pressure to a seller by discontinuing payments.  In the latter the bank generally has no regard for any claims the buyer may possess against the seller and simply demands its’ payment each month.  Generally, no court will interfere with the bank’s rights to security and payment as same are not dependent on the result of any claims possessed by the buyer as against the seller.  The ability to recover in litigation must also be considered.   The distribution of purchase price, whether distributed to creditors or held in joint accounts in a tenancy by the entireties state can impose additional obstacles to recovery and necessarily impacts litigation strategy.  Identification of potential defendants and causes of action is also essential.  Pennsylvania recognizes the torts of negligent misrepresentation in certain circumstances including preparation of financial information for the reliance of others, aiding and abetting breach of fiduciary duty and conspiracy. Accordingly, to the extent a seller was assisted in the preparation of false financial information, those who assisted may also be appropriately identified as defendants when the facts are supportive of liability. Potential claims against a seller include breach of warranty, fraud, misrepresentation, conversion, unjust enrichment and, under the right set of fact, claims for punitive damages.  Breach of warranty claims are often the best chance of success as the issue of intent (or lack thereof) has no bearing on proof of a breach of warranty claim.  

Finally, consider the measure of damages.  Under the right circumstances, lost profits can be claimed. However, post-closing failure (or alternatively, success), management issues and other factors can complicate the damages analysis.  In the absence of a lost profits claim, the difference between the valuation of the company in accordance with the financial information presented and the financial information eventually uncovered may result is a simpler damage calculation.  Of course, any such analysis also requires the assistance of a business valuation expert in addition to the forensic accountant referenced above. A buyer must also be wary of any damage limitations internal to the agreements between the parties as well as any internal statutes of limitations which may be set by agreement. 

In contrast to the ease by which my wife can expel inadvertently consumed sea food, rescission in a business transaction is unlikely.  The very idea of rescission, placing the parties back in their respective conditions, may be impossible based on post-sale performance.  Claims for money damages are far more often the claims that proceed to conclusion.

Certainly, pursuit of litigation concerning the purchase of a business can be expensive and complicated.  Any such decision must weigh the likelihood of success and the cost of that success, against the distraction such litigation may cause and potential impact of that distraction on business operations.  That being said, sometimes a buyer simply has no choice and sometimes what smells rotten really is just that; rotten.    

Last modified on Thursday, 23 October 2014 14:39
Thomas P. Donnelly

Thomas P. Donnelly

Tom’s practice focuses on commercial litigation and transactions. In litigation, Tom represents both Plaintiffs and Defendants. Throughout his career, he has undertaken the representation of both individual and corporate clients in subject matters concerning fraud, contracts, employment agreements, breach of fiduciary duty, securities violations, real estate and insurer bad faith. Tom’s clients include individuals and businesses local to the Philadelphia area, as well as national corporations.

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