Don't Let Your Buyer Walk Away at Closing Time
You're sitting in your office planning your early retirement. With the closing of the sale of your company just three days away, you'll soon join the millionaire club. You can't believe you just spent almost a week listening to your financial advisors and worrying about those financial closing conditions in the purchase agreement. Yes, it's true that the company can't deliver GAAP-compliant financial statements and can't satisfy the minimum net worth requirement. But, does it really matter? After all, the buyer was aware of the deficiencies before signing the purchase agreement. Besides, if the buyer has a problem with the minimum net worth requirement, you can inject cash into the company to artificially boost the company's net worth.
You almost spill your coffee when you open up the confidential letter your secretary just handed to you. The buyer has just notified you that they are walking away from the deal because your company fails to satisfy those financial conditions. Can the buyer do that?
Well, according to the U.S. District Court for the Northern District of Illinois, yes.
The Case
In a recent contract dispute case, Annecca Inc. v. Lexent, Inc., the U.S. District Court for the Northern District of Illinois granted summary judgment in favor of the buyer, Lexent, who terminated a stock purchase agreement based on the failure of the sellers, Annecca's stockholders, to fulfill certain closing conditions, including the sellers' failure to meet certain net worth requirements and to deliver GAAP-compliant financial statements.
In February 2001, Lexent entered into a stock purchase agreement with Annecca's stockholders and agreed to acquire from the stockholders all of the ownership interests in Annecca and its affiliated companies, subject to the satisfaction of certain closing conditions. The agreement included several key provisions which are the subject of the court's analysis.
Conditions Precedent for the Closing
The agreement contained a number of closing conditions, including:
- requiring all of the representations and warranties of the parties to be true, complete and correct as of the closing date (one of the representations and warranties made by the sellers was that Annecca's books, records and accounts accurately and fairly reflect its transactions, assets and liabilities in accordance with GAAP).
- requiring Annecca to have a net worth of at least $9 million as of the closing date.
Termination
The agreement provided that either party was allowed to terminate the agreement if the conditions precedent to its obligations have not been met by the closing date, April 1, 2001.
Notice and Opportunity to Cure
The agreement included a notice-and-cure provision to the effect that if the buyer discovered any condition or matter which the buyer considered unsatisfactory, the buyer would notify the sellers in writing and the sellers would then have 30 days to correct the condition or matter to the sole reasonable satisfaction of the buyer, or the buyer could terminate the agreement on 10 days written notice to the sellers.
Merger Clause
The agreement also contained a typical merger clause to the effect that the agreement represented the entire agreement of the parties and superseded any prior oral understandings or arrangements.
On March 29, 2001, Lexent notified the sellers in writing that it was exercising its termination option, asserting that the two main reasons for its decision were the sellers' failure to fulfill the $9 million net worth requirement and to deliver GAAP-compliant financial statements.
Annecca then filed suit, alleging a breach of the stock purchase agreement. Annecca made a number of arguments, including that:
- it was improper for Lexent to complain that Annecca's financial statements did not comply with GAAP, because Lexent was aware of such GAAP non-compliance when it signed the agreement;
- it was improper for Lexent to terminate the agreement without first giving Annecca the right to cure the deficiencies.
The court concluded that the sellers' representations and warranties that Annecca's financial statements were GAAP-compliant were inaccurate. Therefore, Lexent had a right to terminate the agreement. Annecca agreed that its financial statements were not prepared in accordance with GAAP in all respects, but argued that Lexent was aware of this prior to the execution of the agreement, and therefore should be precluded from terminating the agreement on this basis. The court stated that Lexent's awareness that Annecca's balance sheets were not GAAP-compliant at the outset of negotiations does not alter the unambiguous terms of the agreement as to conditions precedent. The court also stated that the effect of the merger clause is to preclude any such claim based on asserted prior oral understandings.
Annecca admitted in its pleadings that its net worth was between $8.4 and $8.9 million on or about March 31, 2001. Annecca argued, however, that the shortfall was curable because it could have been made up by capital contributions from the sellers. The court admitted that such capital contributions would indeed have resulted in Annecca having the requisite net worth; however, the court interpreted the agreement as requiring the net worth to have resulted from Annecca's "preacquisition activities" rather than capital contributions.
The court stated that Annecca's curability argument ignored the obvious difference between the net worth of a business that is being purchased as a going concern when that net worth has resulted from its preacquisition activities and the net worth of that same business that is artificially boosted by the injection of cash.
After reading into the agreement the requirement that the net worth be created by Annecca's preacquisition activities, the court concluded that the "futility exception" under New York law absolved Lexent from its failure to give Annecca an opportunity to cure. The court stated that unfeasibility of cure and incurability are some of the circumstances that justify a party's decision to bypass the cure requirement and proceed directly to termination. The court found that it was beyond question that the $9 million net worth condition was not fulfilled, and this alone gave Lexent the right to terminate the agreement.
The Lesson?
Here are a few practical points for buyers and sellers to keep in mind:
- Neither a buyer nor a seller should underestimate the significance of closing conditions, including financial conditions. As attorneys may not always be familiar with financial matters, this case illustrates the importance of having the relevant business people review the purchase documents for buyers and sellers, including having accountants and investment bankers review and comment on the financial provisions of the purchase agreements.
- Attorneys, especially buyers' attorneys, may want to revisit the requirement of "minimum net worth" with their client and their client's accountants and investment bankers and carve out any unintended ways to fulfill such requirement. In the Annecca-Lexent case, the court interpreted the agreement as requiring the net worth to have resulted from sellers' preacquisition activities rather than capital contributions. Other courts could have reached a different conclusion since the exception was not provided for in the agreement.
- As most purchase agreements contain merger clauses, sellers should not count on buyers' knowledge of potential problems of sellers to fulfill certain closing conditions as a waiver of such closing conditions.
- The court's decision in the Annecca-Lexent case relies heavily on the sellers' failure to fulfill the closing conditions and not so much on the breach of the representations and warranties of the sellers at the time of signing the purchase agreement. In cases where the representations and warranties of the sellers were not true at the time of signing (and the inaccuracies are known to buyer), but were true at closing, the buyers may not be able to walk away from the deals so easily.
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