Surprisingly, a California Court of Appeals ignores a bank’s rights under a subordination agreement
M&A Stories
December 23, 2022
Introduction
In a recent case, a California Court of Appeals made a surprising decision by disregarding a bank’s rights under a subordination agreement. This ruling has important implications for mergers and acquisitions.
Background
When a business is sold, the seller often receives part of the purchase price as a promissory note, while the buyer secures financing from a bank for the remaining amount. To protect the bank’s interests, both the buyer and seller typically sign a subordination agreement. This agreement ensures that the seller’s right to collect on the buyer’s note is subordinated to the bank’s claim on the acquisition financing.
The Case
In a deal that took place in 2015, a seller sold their business to a buyer who obtained $2.5 million from the seller and $6.2 million from a bank to finance the purchase. Unfortunately, the transaction did not go well, leading to a dispute that ended up in arbitration. The buyer claimed substantial damages from the seller for breaching the purchase agreement, while the seller insisted on receiving the principal and interest owed on the promissory note.
The Lawsuit
In November 2018, the arbitrator awarded the seller damages amounting to $2.8 million, and the buyer received a $2.6 million award for breach of contract damages, including attorney fees, costs, and interest. However, the arbitrator offset these awards without considering the bank’s right to be paid from the buyer’s $6.2 million loan before the seller could receive payment from the buyer’s $2.5 million loan.
Legal Developments: The setoff decision was initially overturned by a California Superior Court due to the subordination agreement. However, on appeal, the arbitrator’s setoff was reinstated on technical grounds.
See E-Commerce Lighting, Inc. v. E-Commerce Trade LLC, No. E074525, Court of Appeals of California, Fourth District, Division Two, (Filed December 9, 2022).
Commentary
The Court of Appeals decision raises concerns as it disregards the bank’s priority of payment clearly established in the subordination agreement. One of the Court of Appeals justices dissented from the decision, acknowledging the significance of the subordination agreement. It remains to be seen whether the bank will pursue this matter further in the California Supreme Court.
By John McCauley: I write about recent legal problems of buyer and sellers of small businesses.
Email: jmccauley@mk-law.com
Profile: http://www.martindale.com/John-B-McCauley/176725-lawyer.htm
Telephone: 714 273-6291
Check out my books: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles and Selling Assets of a Small Business: Problems Taken From Recent Legal Battles
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