Explore the legal intricacies of M&A transactions and learn from a real case – In Re Sanders. Discover how due diligence and reliance on seller representations can impact the dischargeability of seller debts in bankruptcy.
M&A Stories
October 5, 2023
Introduction:
Selling your company carries risks, including potential legal troubles if the business falters post-sale. This could lead to lawsuits from the buyer and even bankruptcy filings by the seller, raising questions about the dischargeability of seller debts in bankruptcy.
Background:
In this case, the seller operated an auto recovery and repossession business since 2004. The buyer, an experienced entrepreneur with a degree from the Wharton School of Business, purchased the company in 2015. Post-acquisition, the buyer uncovered the seller’s deceptive claims about profitability and encountered significant issues with critical bonds, lot leases, and customer contracts.
Legal Proceedings:
The buyer sought to return the business to the seller and reclaim the $1.3 million purchase price. The seller resisted and filed for bankruptcy, aiming to discharge the buyer’s $1.3 million claim. The buyer objected, arguing that the debt shouldn’t be dischargeable due to the seller’s fraud.
Initially, the bankruptcy court ruled in favor of the seller, stating that the buyer could have discovered the business’s problems with due diligence and thus couldn’t reasonably rely on the seller’s fraudulent representations. The buyer appealed and won at the federal district court level, leading to a retrial.
Outcome:
In the retrial, a different bankruptcy court concluded that the buyer had justifiably relied on the seller’s fraud. Consequently, the court ruled in favor of the buyer, declaring the seller’s debt nondischargeable in bankruptcy.
Comment:
Notably, the seller withheld access to the company’s records, and the buyer failed to examine key documents such as bond agreements, leases, and customer contracts, which would have revealed the seller’s inability to transfer them without consent.
Despite these oversights, the court determined that the buyer hadn’t seen warning signs necessitating further due diligence. In hindsight, conducting more thorough due diligence would have saved the buyer time, money, and stress, as all these issues would have surfaced during a comprehensive review of leases, bond documents, customer contracts, and financial records.
Case Reference:
In Re Sanders, Case No. 19-03665-5-JNC, Adv. Pro. No. 20-00018-5-JNC, United States Bankruptcy Court, E.D. North Carolina, Raleigh Division (August 31, 2023).
By John McCauley: I write about recent legal problems of buyers and sellers of small businesses.
Email: jmccauley@mk-law.com
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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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