CONNECTICUT: An Introduction to Corporate/M&A
Lessons from the Save Mart Case
The outlook for M&A activity this year remains uncertain as interest rates remain high and the effects of the upcoming national election and state and federal efforts to eliminate or reduce covenants not to compete continue to remain unclear. With that, there is a recent case of extensive interest to those who specialize in M&A.
Word is filtering out about the unusual set of facts discussed in Delaware Vice Chancellor Laster’s Order upholding an arbitration ruling in SM Buyer LLC and SM Topco LLC v. RMP Seller Holdings, LLC, f/k/a New Save Mart Corp. (Del. Ch. C.A. No. 2023-0957-JTL). In the arbitration ruling that was upheld, former Delaware Vice Chancellor Slights, acting as arbitrator, ruled upon a dispute between the buyer and seller of Save Mart, a chain of California grocery stores, over the post-closing reconciliation of the target’s indebtedness as of the Closing. In the arbitration, V.C. Slights held that by virtue of the post-closing process to determine closing indebtedness, while the buyer had paid the seller an estimated purchase price of approximately USD40M at the closing (including amounts paid into escrow), the seller now owed the buyer USD109M by virtue of the post-closing adjustment process, meaning that the private equity buyer was being paid approximately USD69 million to take the target’s business.
What produced this result? To simplify a long story, the purchase price, as is usual, was set on a “cash free, debt free” basis. The purchase agreement defined “Indebtedness” as including indebtedness of the target and its subsidiaries (as such term was defined in the purchase agreement). The problem arose from the fact that the target had a 51% subsidiary with USD109 million in loan debt. Because this subsidiary was only 51% owned, the seller accounted for its equity interest using the equity investment method of USD22.5 million, rather than by accounting for either 51% or 100% of the subsidiary’s various assets and liabilities on a consolidated basis. Thus, the seller’s share of the subsidiary’s assets were not used in calculating working capital, but the full USD109 million of subsidiary debt was treated as indebtedness under the purchase agreement. The buyer, subsequent to closing, argued that this USD109 million of subsidiary indebtedness, which was not accounted for in the parties agreeing on the preliminary purchase price paid at the closing was indebtedness, which meant that instead of the buyer having to pay USD40 million to the seller for the business, the seller needed to refund the USD40 million and pay the buyer an additional USD69 million, such that on a net basis the seller paid the buyer USD69 million to take the entire company. Vice Chancellor Slights, in the arbitration, sided with the buyer, saying Delaware was a contractarian state and, no matter how surprising or unfair the result was, it was the result the text of the purchase agreement unambiguously called for. V.C. Laster subsequently upheld the arbitration decision, stating that while he would have held differently if he was the arbitrator, the seller had not met the very high standards for the Delaware courts to overturn an arbitration decision.
The end result – that the buyer got to take a thriving business while being paid tens of millions to boot – is obviously shocking. Others will discuss contract interpretation, the ease with which the arbitrator dismissed claims relating to the forthright negotiator principal and mutual and/or unilateral mistake, and the unwillingness of the Delaware court to interfere with an arbitration decision that it disagreed with. Let’s dive into two issues which have gotten less attention. First, as the relevant terms in the purchase agreement arose from an agreement that originally came from the seller’s attorneys, with the relevant portions not having been materially changed during negotiations, is there language that should be in a seller’s first draft that would make this type of result less likely? Second, did the buyer’s counsel have an ethical obligation to act differently than it did?
It is difficult to believe, in a deal this size, and with the particular attention paid to this specific subsidiary in structuring the deal, that not one of the seller’s officers, attorneys or accountants noticed how the literal reading of the purchase agreement would apply to the instant facts to produce this bizarre a result. But, if in two instances the seller’s counsel’s model forms had contained slightly different provisions, it would have been more difficult to totally miss the issue. First, in the definition of “Indebtedness”, do not start with “the indebtedness of the target and its subsidiaries” but with “the indebtedness of the target and its wholly-owned subsidiaries.” When (presumably) buyer’s counsel then moves to strike out “wholly-owned,” it will force seller’s counsel to ask if there are any subsidiaries that are not wholly-owned and, if so, how that will affect calculations of both indebtedness and working capital. Second, when using the term “accounting procedures,” “accounting principles” or something similar to refer to the text in the agreement (or a separate schedule) that sets forth the procedures for calculating working capital, make sure that the terms also apply to the calculations of indebtedness, seller’s transaction expenses and anything else that is recalculated post-closing, and for which the purchase price is then adjusted. Doing so would insure that the accountants’ drafting and the lawyers’ drafting are not totally separated, and that any thoughts that the accountants have on indebtedness (or cash or other balance sheet items) actually tie into the agreement, as opposed to a purchase agreement that only ties the accounting principles to the “working capital” determination.
Did buyer’s counsel act unethically in not pointing out to their counterparts before signing that seller’s calculation of the closing payment was ignoring the deduction to be made for the subsidiary’s indebtedness? Assuming that the ABA Model Rules governed the buyer’s attorneys, Model Rule 4.1 prohibits a lawyer from “knowingly mak[ing] a false statement of material fact or law to a third person.” There might be an ethical issue if the buyer’s counsel was asked if it thought the pre-closing calculation of indebtedness was correct, and the buyer’s counsel said “looks good to us” knowing, in fact, that they were going to make a claim for a USD109 million adjustment in the post-closing reconciliation process. Model Rule 4.1 does not, however, put an affirmative obligation on them to tell seller’s counsel that they must be misreading the agreement. Rule 8.4(c) states that “[i]t is professional misconduct for a lawyer to engage in conduct involving dishonesty, fraud, deceit or misrepresentation.” Would that Rule allow buyer’s counsel to sit silently while the seller presents the buyer with a calculation of indebtedness off by a whopping USD109 million?
While facts matter, it is not clear that sitting silently by while you see that the seller is misinterpreting the terms of the contract, absent a statement from the buyer’s side saying they agree with the calculation, fits within the “dishonest, fraud, deceit or misrepresentation” prohibition. Further, remember that Rule 1.6(a) also comes into play, as it prevents a lawyer from “reveal[ing] information relating to the representation of a client unless the client gives informed consent, [or] the disclosure is impliedly authorized in order to carry out the representation ….” In other words, there may have been an ethical issue in the buyer’s counsel freely offering up advice to the seller’s counsel as to what the drafted language meant if such a disclosure was adverse to the buyer. From the facts set forth in the arbitration decision, it does not appear that there is a basis for concluding (as opposed to speculating) that the buyer’s counsel acted contrary to the Model Rules. Asking whether the buyer’s counsel may have acted unethically not under the Model Rules but outside of them is a fair question, but for another day. Before jumping to that conclusion, however, one should keep in mind that it is dangerous to judge the ethics of another absent complete facts and the requirements of Model Rule 1.6(b).