Private Equity

A private equity firm is the buyer of a business that has just received a letter from one of that purchased business’ customers stating that the customer “believes” that the purchased company may have violated its contract with that customer.  The letter states that the customer is investigating the matter and requests information to assist in that investigation.  The facts the customer is investigating relate to a period of time prior to the buyer’s purchase of the business.  In the Stock Purchase Agreement pursuant to which the buyer acquired the business, the seller represented that this contract was in full force and effect and the company was not in default.  The buyer believes this could be a major problem as the customer accounts for 25% of the company’s business and, if the facts are true, the customer could potentially terminate the contract.  So, the buyer determines that it should send out a claim notice under the indemnification procedures set forth in the Stock Purchase Agreement “to preserve its claim,” as the survival period for the representations and warranties expires in the next few days.

Unfortunately, when the indemnification procedures are reviewed as part of the preparation of the notice letter, the buyer discovers that there is a problem:  in order to make an indemnification claim, the buyer is required to allege an actual breach of the representations and warranties in the agreement, or allege the existence of actual or threatened litigation arising from an actual breach, not just the possibility that there may be a breach—and that has not happened here before the end of the survival period based on the letter from the customer.  The agreement simply does not permit a so-called “placeholder” claim that alleges that facts have come to the buyer’s attention that “may result in a default.”  If you are the seller this may well have been your intent—i.e., to bar any claim that has not ripened into a real claim by the end of the survival period.  As a buyer, maybe not.  And private equity firms are sellers just as often as they are buyers.

Words matter.  “Will” is not the same as “may” for example; and “incurred, suffered or paid” is different than “may suffer or incur,” as is “possibility of breach,” much different than simply “breach.”  And the phrase “threatened action” requires an actual warning that an action is going to be commenced—simply alerting another party of the existence of an issue without making clear that the intent was to resolve it through litigation may not rise to the level of “threatened action.” As noted by one recent Delaware case, I/MX Information Management Solutions, Inc. v. Multiplan, Inc., “[t]he mere notice of an issue, standing alone, does not trigger [plaintiff’s] indemnification rights under the Agreement. Rather, [the third party] had to threaten to do something about that issue, namely, commence an Action.”  And even if a third party did so threaten, and that threat indicates that there may well be other problems with other similar agreements with other customers for which there has been no such threat, does not necessarily permit the buyer to make a “placeholder claim” based on the likelihood of those other claims being made if they have not in fact been made by the expiration of the survival period—unless, of course, the agreement so provides.

Another recent Delaware decision, Rexam Inc. v. Berry Plastics Corp., reinforces the importance of choosing your words carefully.  In this case, the court held that correspondence from a governmental agency that (1) expressed disappointment with a transaction, (2) stated that the assumptions used in justifying the transaction “fell short of the reasonable standard,” and (3) stated that while “it had ‘not yet decided whether … [to] pursue this matter[,]’” “it ‘[did] not plan to initiate legal action … at this time.’” was not a “threatened” legal or administrative action. Instead, it was “merely an identification or reservation of options” by a “frustrated governmental agency.”  In other words, the standard agreed to was not whether it is “possible” that an action would be brought based on the unhappiness of a governmental agency, but whether there had been an overt threat that such an action would be forthcoming.   As noted by the court, “[i]t is a fine line, but sometimes fine lines must be drawn.”

For example, as a buyer you might want to think twice about a provision like this one that was plucked from a publically available agreement, which would appear to eliminate any placeholder claims:

No claim for indemnification for breach of any representation, warranty, covenant or agreement contained in, or otherwise pursuant to, this Agreement (other than any covenant (excluding this Article XII) that provides for performance following the Closing) may be asserted pursuant to this Agreement unless (i) on or before the Survival Expiration Date, such claim is asserted by proper written notice in accordance with this Article XII, specifying, in reasonable detail, the basis of the claim and (ii) such claim is made in respect of Damages specified, in reasonable detail, and incurred prior to the Survival Expiration Date.

And as a seller you might want to try and limit this seemingly opened-ended ability to make placeholder claims that was also plucked from another publically available agreement:

The representations and warranties and pre-Closing covenants and agreements of Purchaser, Sellers and the Company contained in this Agreement will survive the Closing until the fifteen (15) month anniversary of the Closing Date …, except that … any representation, warranty, covenant or agreement that would otherwise terminate in accordance with this Section 11.01 will continue to survive if the requisite claim notice shall have been timely given in good faith based on facts reasonably expected to establish a valid claim under this Article XI on or prior to such termination date, until the related claim for indemnification shall have been satisfied or otherwise resolved as provided in this Article XI.

If the purpose of a survival period for the seller is to have a clear end date to indemnification claims being made so that the remaining proceeds of the sale can be distributed to the seller’s limited partners, something more than notice of a good faith claim that a breach may be established in the future, after the expiration of the survival period, should be required. On the other hand, it is understandable why a buyer may want the ability to preserve a potential claim past the end of the survival period if it has received information that establishes the likelihood that there has been a breach of the otherwise expiring representations and warranties, even though that breach has not clearly manifested itself as of the end of the survival period.  But regardless of which side of these arguments on which you find yourself, it is important that the agreement clearly reflect the resolution of this issue in words that are understood.