Private Equity

A recent Delaware Court of Chancery decision, Deluxe Entertainment Services Inc. v. DLX Acquisition Corporation, 2021 WL 1169905 (Del Ch. Mar. 29, 2021), provides a stark reminder of the need to carefully provide, in your stock purchase agreement, mechanics for the transfer by the target to the selling shareholders of any assets that remain in the target at closing that were intended to be excluded from the sale of the target and retained by the selling stockholders. In Deluxe Entertainment, the buyer was entitled to keep all cash held in target bank accounts after closing, even though cash had been excluded from the net working capital adjustment (i.e., the seller received no credit for the amount of cash left in the target’s bank accounts), and the seller could have swept the cash from the target immediately prior to closing, but failed to do so.

The failure to provide different mechanics to accommodate the distinctions between asset and stock transactions can cause real issues to one or both parties to a stock purchase agreement. In a stock transaction, the buyer acquires the shares of the target from the target’s shareholders; and the assets of the target remain with the target notwithstanding the change in ownership of the target. If there are assets in the target that the selling shareholders wish to retain, they need to distribute those assets out of the target prior to the sale so they no longer belong to the target at the time ownership of the target changes. Shareholders selling stock in a target company cannot simply exclude assets of the target company from passing with the target in a stock sale and thereby purport to retain such assets—unless the target itself transfers those assets, they remain with the target. In an asset transaction, on the other hand, the buyer acquires assets of the target directly from the target. If there are assets in the target that the target wishes to retain, it simply excludes those assets from the sale.

In real life of course, things are not so straightforward and simple. Even in a stock sale there are circumstances where the assets necessary to operate the business intended to be sold are not exactly where they need to be. The target may have assets belonging to another business unit or another company in the corporate chain may own an assets that should properly be part of the business being sold as part of the sale of the target company. Often these objectives are accomplished through a pre-closing restructuring of the entities conducting the various businesses in the corporate group, with the target transferring certain assets to other corporate group members and other corporate group members transferring certain assets to the target. As a result there may be circumstances after closing in which the target, as the former owner of assets transferred pre-closing, may receive payments to which another group company is properly entitled, or another group company may receive payments related to assets to which the target is properly entitled. The stock purchase agreement will typically address these issues with so-called “wrong pocket” provisions, which obligate each party to pay over wrongly received payments (and liabilities related to these assets may need to be dealt with similarly). 

In Deluxe Entertainment, the seller had negotiated a deal which it believed had been priced on a “cash-free, debt-free” basis. And based on the assumption that there would be no cash remaining in the business after the closing, the net working capital adjustment had been specifically negotiated to exclude cash as an asset in the calculation. Moreover, the agreement apparently contemplated some transfers of assets in and out of the target before closing to ensure that the assets of the target were where they needed to be. And to clarify what should not have ended up in the target, the agreement contained a list of Excluded Assets and certain “wrong pocket” provisions to ensure that the target was obligated to transfer to the seller any of the Excluded Assets and related payments if they mistakenly ended up in the target. Notably, however, cash was not listed as an Excluded Asset; the “wrong pocket” provisions, therefore, were inapplicable. 

The stock purchase agreement was apparently clear, however, that the seller was entitled to sweep the cash out of the target company before the closing. But, “for various practical and technical reasons,” the seller failed to sweep the cash out the target before the closing. After closing, the seller requested that the target send the unswept cash to the seller. The target refused and this lawsuit followed. Because the stock purchase agreement was unambiguous, the sale of stock of the target carried with it all of the assets held by the target (including the unswept cash held in its bank accounts), and the net working capital adjustments exclusion of cash was just a means of determining the ultimate price paid for the stock (not whether cash was an asset intended to be excluded from the sale), the court granted the buyer’s motion for judgment on the pleadings and the seller’s complaint was dismissed.

The efforts of the seller to reform the agreement based upon mistake were also unavailing. According to the court, the mistake here was not in the terms that were incorporated into the purchase agreement, but the seller’s “operational” mistake in failing to sweep the cash prior to the closing:

Seller’s failure to sweep Target’s cash is an operations or accounting mistake, which is crucially distinguishable from a scrivener’s error in the underlying agreement itself that can be remedied by reformation. Seller’s mistake in its own preparation to perform the parties’ accurate agreement cannot justify reforming that agreement. Seller bears the risk of that mistake. The Court will not change the terms of the parties’ bargain to accommodate Seller’s error in preparing to perform under the agreement that reflects that bargain.

Obviously this result could have been avoided either by including cash in the working capital adjustment on the theory that it is always difficult to sweep all cash and any cash remaining should be paid for by the buyer, or by listing cash as an Excluded Asset and making sure the “wrong pocket” provisions provided for the transfer to the seller of any cash remaining in the target at closing. But that did not happen. As noted in an earlier decision by the Delaware Court of Chancery, Zohar II 2005-1, Limited v. FSAR Holdings, Inc., 2017 WL 5956877 (Del Ch. Nov. 30, 2017), “[w]ords parties use to bind themselves together in a contractual relationship matter,” and Delaware’s contractarian principles are “not prone to outcome-driven variability,” even in the face of “impassioned pleas to the court’s sense of fairness in the midst of a potentially harsh result.”