Buy Right Cars – Earn-Outs again

Introduction

In what was a preliminary skirmish about procedural issues, an earn-out was again the focus of attention in a High Court decision released last week.

The background is that the former owner of the Buy Right Cars dealership, which was purchased by Turners in 2016, is suing Turners for $5.5 million, claiming Turners tried to avoid paying him under earn-out provisions in the SPA.  In the lead-up to a full hearing, which is scheduled for May 2020, the vendor sought ancillary orders seeking more information, suggesting that the driver for seeking additional information was a precursor to seeking a “freeze” order.

The applicant sought discovery of information about Buy Right Cars’ financial performance after August 2018, including minutes of meetings, board reports, monthly accounting and information about decisions.  It told the High Court that a “freeze” order might be needed because Turners was getting rid of assets and might not be able to pay up if he wins.

Decision

In declining the application, Justice Anne Hinton said that she while understood the applicant’s concerns over Buy Right Cars’ March 2019 result and the write-off of the brand, it wasn’t enough to make the orders.  Instead, the judge found that on the evidence as it currently stands, she was not prepared to find that there is a danger going forward of assets being disposed of, dealt with or diminished in value leading to a danger that a prospective judgment debt may not be wholly or partly unsatisfied.

Instead, the judge noted that the brand write-off has occurred and, based on market research, it should have a positive future effect on profitability.  Decisions about closing down a branch are in the ordinary course of business and in any event, seem to be some time off.  The inventory change cited is not as drastic as the vendor thought was an ordinary course of business decisions.

And the Courts have made it clear that diminution in value of assets in the ordinary course of business, (although on the face of it not excluded from the test for a “freeze” order) is not to be met with a freezing order.

In an addendum to her decision, the judge said in her view the extent of the orders sought was unnecessary, despite being aware relations had soured between Turners and the applicant.  Instead, she said that she would have thought it would be productive for the parties to find a way in which the Turners’ basic 2019 financial statements and related information could be provided to the applicant’s lawyer and/or independent accounting adviser on the basis of non-disclosure to the applicant, because:

“This is not a case where there is the usual concern over providing a plaintiff with details as to a defendant’s financial position. The plaintiff will have had many of those details until a year ago and is not in competition with the defendant.”

Background – the Earn-out

Part of the Turners’ acquisition of Buy Right Cars involved an earn-out, based on the performance of Buy Right Cars over the 2 years following completion –year end 2017 (Earn-out 1) and 2018 (Earn-out 2).  The founder of Buy Right Cars was to remain in control of the business for the earn-out period.  For Earn-out 1, the vendor received $3.4m. 

In 2017, the parties agreed to a variation to the SPA in which the founder relinquished day-to-day responsibility for the business and received a $1m non-refundable advance on account of Earn-out 2.  However, the business performance for Earn-out 2 was such that the vendor received nothing above the $1m advance.  The vendor is claiming much more for Earn-out 2.  The claim is based on a breach of a fundamental covenant that the purchaser (Turners) would not take any action that would adversely affect the business during the earn-out period.  Under the SPA, if the purchaser breaches a fundamental covenant, the full amount of the earn-out becomes payable, regardless of whether applicable performance targets have been met.

Post-completion changes

Whilst this was an application for interim orders and it is not possible to get more than a short-handed view of the basis of the parties’ respective positions, this snapshot neatly illustrates one of the fundamental tensions inherent in any earn-out negotiation.

That is, the tension between:

• vendor’s basic interest is in maximising the earn-out payment; and
• (by contrast) the purchaser’s interest in not only achieving short-term goals, but also ensuring that the business achieves its long-term objectives (including the ability to sustain and build on its profitability), 

because vendors and purchasers often have very different ideas of how the business should be run. 

As a result, the objective when negotiating an earn-out is to find the right balance – so the earn-out calculation is predictable, but also copes with the way the business is operated following completion. 

Typically, the earn-out should require the purchaser to act in good faith to achieve the earn-out (some commentators suggest that the Courts should imply such an obligation).  However, by acting in good faith, a purchaser should have room to make good faith business decisions that (like any business decision) have the potential to have an adverse impact on the earn-out. 

Arguably, a vendor should be able anticipate the most likely operating  decisions that could adversely affect the earn-out and ensure that they are addressed (by way of covenant in the SPA) to specifically address those decisions.  From the limited evidence available in the Buy Right Cars decision, it would appear that decisions to rationalise premises and staff were not seen as adverse, and that a decision to reduce stock volumes was not regarded as triggering a “fundamental” breach.  The decision to write off the brand is likely to be the subject of further argument – but the more fundamental issue seems likely to be one which points to a keenly-contested debate about whether changes to business practices led to profits being booked elsewhere in the (purchaser) business group. 

Without being able to see all of the evidence and (particularly) get an understanding of the language protecting the vendor against breaches of a fundamental covenant (triggering an obligation to pay the full amount of the earn-out) it is difficult to comment further.

Further information

If you would like more information about any of the matters discussed in this note, please contact me.