Beware of Post-Closing Actions Having a Retro-Active Pre-Closing Impact

We are now in September, and with the turn of the Gregorian calendar, comes the unofficial end of summer for both the United States and Israel.  Most have taken their summer holidays, the children are back in school, and the company transaction environment gains new momentum for the balance of the calendar year.  It is a good time to reflect.

When selling the equity of a company, Sellers expect Buyers to require a representation and warranty that (1) all taxes of the company have been paid or reserved on the target’s balance sheet and (2) all tax returns previously filed were true and correct.  No news there.  In return, experienced Sellers will require the Buyer (who will now own the target company) to covenant not to amend any of the target’s pre-closing tax returns in a manner that would trigger indemnity liability by the Sellers.  Again, no news there.  But consider this scenario, not with regard to tax returns, but with regard to the closing financial statements, in particular, the balance sheet:

The sale of 100% of the equity in the target company closed during the course of the calendar year.  The target’s business was of a nature that governmental fees (in the nature of a tax; but not an income tax) were assessed looking at the number of imports for the entire calendar year.   The rate of assessment was graduated; meaning that the higher the level of imports, the higher the percentage used for the assessment.  The Sellers had caused sufficient amounts to be reserved on the target’s balance sheet to fully fund the liability for the governmental fees based on the level of activity that was not only in accordance with the ordinary course of business of the target company, but also using a methodology that was industry standard.  The transaction closed.

Just before the end of the calendar year, the Buyer (now in control of the target) caused a massive importation of product to occur.  Because the governmental fees were calculated only on the total for the year regardless of timing, the Buyer claimed that insufficient amounts were reserved on the target’s balance sheet, the closing working capital was short, thus justifying a claim against the Sellers for a reduction in the purchase price.    Why did the Buyer do this?  The Buyer chose to import goods in year 1 (the year of the closing), to intentionally accelerate the governmental fees and seek to have the Seller to underwrite a significant portion, so that in year 2, Buyer would have the goods on hand to sell in the market with the governmental fees already paid.  Buyer’s position was that it was their company after the closing, and they could run it as they wished.  They were not amending any pre-closing tax returns, so were not in violation of that provision.

While it is common in transactions for Sellers to represent and warrant that from some agreed point in time (often the end of the last quarter or the date of signing) until closing, the target company was run in the ordinary course of business, what is not generally requested is any form of covenant that Buyer run the target in the ordinary course of business and in accordance with past practice for some period of time after the closing.  One can imagine considerable objections from a Buyer to such a suggestion; again on the premise that after closing, it is their company and they can run it as they wish.  But perhaps a prudent course for Sellers would be to borrow the same concept used for amending tax returns to post-closing actions that impact the closing balance sheet.  Buyer may run its newly acquired company as it wishes, but any post-closing actions it takes cannot be used to trigger an adjustment to the purchase price or cause a representation and warranty which was correct at the time made, to be made untrue due to retroactive application of post-closing actions of Buyer.  This will not be an easy point for Seller and its counsel to win, but it may well be worth the effort.

Related Capabilities

Media Contact

Public Relations Contact
Kate Lenders
Senior Marketing Manager
klenders@sgrlaw.com
312-360-6478