What Not to Do After a Merger

October 31st, 2008

I like reading court decisions for two reasons.  One is that they sometimes set new rules, which is vital information, of course.  More often they serve as reminders of how to do things (or not to) and why agreements and transactions are structured in certain ways.  Here is one that does both: Western Filter Corp. v. Argan, Inc.

The Facts
The very quick plot summary is that Western Filter bought its competitor Puroflow (a subsidiary of Argan) in October 2003 for $3.5M.  The purchase agreement said that certain representations and warranties in the agreement would survive for a year after closing.  10.5 months after closing, Western Filter sent Argan a letter saying that Puroflow’s inventory was short of the representations by ~$2M, and Western Filter filed a claim six months after that (outside the 1 year period) alleging breach of the representations.

The Issue
The legal question for the court was whether the one-year survival language meant that (a) Argan agreed to maintain the reps & warranties as true for a year after closing without touching the 4 year statute of limitations on contract claims in California (Western’s argument), or (b) the one-year language meant that Western Filter could only file claims within a year after closing instead of the normal 4 years (Argan’s argument).

The Ruling
The court decided that Argan’s reasoning made sense, but Western’s reading was also possible and that existing law therefore required deference to Western’s interpretation.  The court held that the intent was to hold the reps open for a year, and more importantly that agreements to shorten statutes of limitations must be clear and unambiguous.  The important takeaway for lawyers, then, is that we need to be extremely specific if we intend to shorten statutes of limitations.  Duly noted.

The Nonsense
This is an unfortunate outcome on the facts.  It is impossible to require a seller to maintain representations and warranties correct for a year after closing a merger.  By definition, the seller has lost control of the business after closing, so responsibility for maintaining inventory levels in the year after the deal is and should be entirely on the buyer.  The court wiggles around this a little by saying “one year after closing” meant that the reps were true at closing and that Western had one year afterward to discover a breach- and then another three to file an action.  This is slicing hairs much too thin.  Argan’s argument is the better one here and the court acknowledges that while saying at the same time that precedent requires a clear, definite statement to shorten the statute of limitations.  This is a great example of a clear, bright-line rule producing a bad result on the facts.

What Should Have Happened
This is the “why we do things certain ways” part.  Every merger I have ever been part of has had a “truing-up” section where the buyer does a full review of the acquired business immediately after the acquisition and adjusts the purchase price as needed.  In this case the parties had set aside a $350,000 reserve to do that, which was apparently not enough given the size of the inventory discrepancy.  Still, if Western had done this review timely it would have been able to file a claim within the one-year period and everyone could have moved on instead of spending the next four years figuring out whether the claim could even be pursued.

And the Lessons
Legal: if you intend to shorten a statute of limitations, be clear about it.

Practical: when you close a deal, follow up immediately to be sure you got what you paid for.  Don’t squander your rights.

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