An April 11, 2024, article in the Financial Times, “The inequity method of accounting: California family learns about private-equity hardball while selling supermarket chain,” has created a stir in the private equity deal community. The article details a dispute that arose between the prior owners of Save Mart, a California supermarket chain, and Kingswood Capital Management, a Los Angeles–based, lower-middle-market private equity firm. While the article is recent, the arbitration award detailed in the article was handed down on September 5, 2023, and confirmed by the Delaware Court of Chancery on February 28, 2024. Prior to the Financial Times article, the case received little attention. But the seeming harshness of the arbitration decision as detailed in the article (selling stockholders being required to pay the buyer approximately $70 million for the buyer to acquire the company), coupled with the Court of Chancery’s confirmation of it, has many in the deal community gobsmacked.
So, I decided to delve into it a bit more deeply and look at the actual provisions at issue to the extent obtainable. (Because the otherwise private arbitration ruling was posted by the Financial Times and is therefore publicly available, we have direct quotations from the purchase agreement to review.) What I have managed to learn from the available documents follows.
Save Mart Supermarkets, LLC operated over two hundred stores in California and Nevada. Save Mart also was a general partner in (and owned an equity interest of approximately 52 percent of) Super Store Industries (“SSI”), a separately run partnership with two other partners that operated a wholesale grocery distributor business. SSI had debt on its balance sheet of approximately $109 million. This debt was not on Save Mart’s balance sheet because SSI was an unconsolidated subsidiary, and Save Mart had elected to account for the SSI partnership using the equity investment method, meaning that Save Mart reflected on its balance sheet its net investment in SSI (SSI’s asset value less SSI’s debt, multiplied by Save Mart’s ownership interest). Save Mart’s latest balance sheet prior to its sale reflected its joint venture investment in SSI at a net $22.5 million. In other words, the SSI debt was well covered by the assets of SSI (and the SSI debt was current and had never been in default).
Kingswood Capital formed SM Buyer LLC (“Buyer”) to acquire Save Mart from its owners (“Sellers”). Buyer and Sellers entered into an Equity Purchase Agreement (“EPA”) on March 7, 2022. The deal was structured as a “cash free, debt free” deal, with an agreed “Base Value” of $245 million. Consistent with the “cash free” concept, the EPA permitted the Sellers to sweep all cash out of Save Mart prior to closing, and they in fact swept $205 million out of Save Mart prior to closing.
As is typical, the purchase price was determined by a formula that started with the base value and then subtracted closing date indebtedness and transaction expenses and added or subtracted other items, such as working capital excesses or deficiencies. The EPA contained a purchase price adjustment mechanism to address that calculation. It provided for (a) the Sellers to prepare an estimated closing statement a few days prior to closing (which the Buyer was entitled to comment upon and which provided the basis for the estimated purchase price to be paid at closing), (b) the Buyer to then, within ninety days after the closing, prepare its own closing statement consistent with the contractual guard rails, and (c) any dispute between the Sellers’ estimated and Buyer’s closing statements to be resolved by accountants or courts depending on the issue.
The definition of “Purchase Price” read as follows in the EPA (prior to an amendment that separated the sale of the SSI joint venture interest from the sale of the rest of Save Mart):
The aggregate consideration payable by Buyer in respect of the Company Membership Interests shall be an amount equal to (a) the Base Value, plus (b) the amount, if any, by which the Working Capital exceeds the Working Capital Target, minus (c) the amount, if any, by which the Working Capital Target exceeds the Working Capital, plus (d) the Closing Cash (which may be a negative number, in which case, Closing Cash shall reduce the Base Value), minus (e) Closing Date Indebtedness, minus (f) Transaction Expenses, minus (g) Deemed Accrual Amount (such resulting amount pursuant to clauses (a)-(g), and as such amount may be adjusted pursuant to the provisions of Section 1.4, the “Purchase Price”).
The key deduction from Base Value here was “Closing Date Indebtedness.” Closing Date Indebtedness was defined in the EPA as “the aggregate amount of all Indebtedness of the Group Companies as of the Adjustment Time.”
Indebtedness was defined very broadly to include:
among other things, “(i) the outstanding principal amount of and accrued or unpaid interest of (A) indebtedness of such Person or its Subsidiaries for borrowed money (including Debt Breakage Costs) and (B) indebtedness evidenced by notes, debentures, bonds or other similar instruments for the payment of which such Person or its Subsidiaries is responsible or liable,” and “(xi) all liabilities and obligations of the type referred to in clauses (i) – (x) of other Persons for the payment of which such Person or its Subsidiaries is responsible or liable, directly or indirectly, as obligor, guarantor or surety.”
Group Companies was defined to include Save Mart and its “Operating Subsidiaries.” Operating Subsidiaries was defined to include “all direct and indirect Subsidiaries of the Company [listed on Section 3.4(b) of the Company Disclosure Schedule].” SSI was in fact listed as an Operating Subsidiary on Schedule 3.4(b). Adjustment Time was defined as 11:59 p.m. PT on March 27, 2022, which was the day before the closing at 8:00 a.m. PT on March 28, 2022.
However absurd it may seem given the balance sheet accounting treatment of the SSI investment (net equity value), the strict language of the definition of Closing Date Indebtedness appears to cause all of the SSI debt (a revolver and a real estate loan, totaling $109 million) to be included.
At some point, the Buyer’s financing sources had apparently expressed concern about the potential for a creditor of SSI to directly sue Save Mart as a general partner of SSI. As a result, the Buyer asked the Sellers to restructure the deal so that Save Mart was no longer a direct partner of SSI immediately prior to the closing. They did this by amending the EPA (the “EPA Amendment”) to provide that immediately prior to the closing, Save Mart’s partnership interest in SSI would be distributed to the Sellers, who would then contribute that partnership interest to a newly formed entity (“SSI Holdco”). The Sellers would then sell the equity in SSI Holdco to a newly formed affiliate of the Buyer (“Topco”) for a fixed purchase price (not subject to any adjustment) of $90 million. As a result of the proposed pre-closing SSI spinoff required by the EPA Amendment, as of the closing date (a) Save Mart would no longer be a general partner of SSI, and (b) SSI would no longer be an Operating Subsidiary of Save Mart.
In the Amended EPA, the definition of Purchase Price was changed to read as follows (changes in bold):
The aggregate consideration payable by Buyer in respect of the Company Membership Interests shall be an amount equal to (a) the Base Value, plus (b) the amount, if any, by which the Working Capital exceeds the Working Capital Target, minus (c) the amount, if any, by which the Working Capital Target exceeds the Working Capital, plus (d) the Closing Cash (which may be a negative number, in which case, Closing Cash shall reduce the Base Value), minus (e) Closing Date Indebtedness, minus (f) Transaction Expenses, minus (g) Deemed Accrual Amount, minus (h) the SSI Purchase Price (such resulting amount pursuant to clauses (a)-(h), and as such amount may be adjusted pursuant to the provisions of Section 1.4, the “Purchase Price”), and the aggregate consideration payable by Topco in respect of the SSI Holdco Membership Interests shall be an amount equal to $90,000,000 (“SSI Purchase Price”).
But the definitions of Group Companies, Indebtedness, Closing Date Indebtedness, and Operating Subsidiary all remained unchanged. And notably, Schedule 3.4(b) continued to list SSI as an Operating Subsidiary, which was accurate pre-closing, but not post-closing when it mattered. Including all SSI debt in Closing Date Indebtedness made little sense before the SSI spinoff given the accounting treatment on Save Mart’s balance sheet, but it made no sense following the SSI spinoff because, post-closing, SSI was no longer a Group Company of Save Mart.
As required by the EPA, the Sellers prepared an estimated closing statement three days prior to the closing. The Buyer made several comments, and the Sellers made revisions to accommodate the Buyer’s comments. Notably, the Sellers did not include the SSI debt in the Closing Date Indebtedness for purposes of computing the estimated purchase price, and the Buyer did not object to the Sellers’ failure to do so. The estimated closing statement prepared by the Sellers reflected a purchase price to be paid by the Buyer to Sellers for Save Mart of approximately $39.5 million, of which approximately $7 million was to be deposited into an escrow account. The closing was then consummated based upon that estimated closing statement.
Pursuant to the terms of the EPA, the Buyer then prepared its own closing statement within ninety days after the closing; in that statement, the Buyer included the $109 million of SSI debt as a deduction from the Base Value for the purposes of determining the final purchase price. The provision in the EPA detailing how the Buyer was supposed to prepare its closing statement is set forth below in relevant part (emphasis added):
Closing Statement. No later than ninety (90) days after the Closing Date, Buyer shall cause to be prepared in good faith and delivered to Seller a statement (the “Closing Statement”) setting forth Buyer’s calculation of the Purchase Price (the “Closing Date Purchase Price”). The Closing Statement shall be prepared in a manner consistent with the definitions of the terms Working Capital, Closing Cash, Closing Date Indebtedness, Transaction Expenses, including, as applicable, the Accounting Rules (including as reflected on Exhibit A). The Parties agree that the purpose of preparing the Closing Statement and determining the Working Capital, Closing Cash, Closing Date Indebtedness, and Transaction Expenses is to measure the amount of the Working Capital, Closing Cash, Closing Date Indebtedness, and Transaction Expenses and such processes are not intended to (x) permit the introduction of accounting methods, policies, principles, practices, procedures, classifications or estimation methodologies for the purpose of determining the Working Capital, Closing Cash, Closing Date Indebtedness, or Transaction Expenses that are different than the Accounting Rules or (y) adjust for errors or omissions that may be found with respect to the Company Financial Statements or any inconsistencies between the Company Financial Statements and GAAP (except to the extent resulting from the application of the Accounting Rules in accordance with this Agreement).
There were disputes beyond whether the $109 million should have been included as part of Closing Date Indebtedness, and those disputes were referred to an accounting referee for resolution. But for reasons that are unknown (and must now be regretted by the Sellers), the parties agreed to submit the SSI debt inclusion dispute to binding arbitration before a retired former vice chancellor of the Delaware Court of Chancery (the “Arbitrator”), as opposed to litigating the dispute in court.
In the final arbitration award, the Arbitrator appears to concede that all of the extrinsic evidence suggests that the SSI debt was never intended to be a deduction to the purchase price. However, based upon Delaware’s strong contractarianism, he concludes early on that:
As explained below, the issues as framed by the parties distill down to a choice between two arguably unsatisfying outcomes: apply the clear and unambiguous terms of the operative contract and reach a result that is in tension with the extrinsic evidence; or follow that extrinsic evidence to a result that cannot be squared with the clear and unambiguous contract as written. That the resolution of the dispute, either way, will effect a material shift in the deal dynamics makes the choice between these outcomes all the more unsatisfying. But the choice, ultimately, is not difficult. The parties contractually invoked Delaware law and that election is consequential. Delaware law is more contractarian than most, and Delaware courts will enforce the letter of the parties’ contract without regard for whether they have struck a good deal or bad deal. Absent a contractual ambiguity, extrinsic evidence is inadmissible to construe the contract. The purchase agreement is not ambiguous. And the buyer has proffered the only reasonable construction of the contract’s operative provisions. Delaware law accordingly mandates that I adopt the buyer’s interpretation and ignore the extrinsic evidence.
The Sellers valiantly attempted to find places in the agreement (which after all must be read as a whole) to suggest that Buyer’s interpretation was not in fact the only reasonable interpretation, and that there was a perfectly valid interpretation that supported the Sellers’ view of the meaning of the term Closing Date Indebtedness in context of these other provisions (without necessarily relying on extrinsic evidence). Among those other provisions were the references to Accounting Rules and the fact that the EPA expressly forbade the “introduction of accounting methods, policies, principles, practices, procedures, classifications or estimation methodologies for the purpose of determining the Working Capital, Closing Cash, Closing Date Indebtedness, or Transaction Expenses that are different than the Accounting Rules.” The argument was that since the SSI debt had always been recorded under the net equity method of accounting, treating the entire SSI debt as if it were Indebtedness would be violating this provision. But after extensive analysis, the Arbitrator concluded that the Accounting Rules largely pertained to the calculation of Working Capital and could not overcome the clear definition of Closing Date Indebtedness. It is important to note here that the comparison was not to alternative balance sheets and differing methods of accounting for the debt, where the prohibition of changing methods of accounting may have had some applicability; instead this was a simple calculation of defined debt (which never mentioned applying accounting methods to determine the components of that defined debt).
There were other arguments based on isolated provisions of the EPA, including the fact that the SSI debt was listed as an Undisclosed Liability in the representations and warranties section of the EPA and, in context, Undisclosed Liabilities were stated as being in addition to Indebtedness that was otherwise included in calculation of the Purchase Price (emphasis added):
Undisclosed Liabilities. Except as set forth on Section 3.6 of the Company Disclosure Schedule [which listed the SSI debt only], neither the Company nor any of the Operating Subsidiaries have any material Liabilities, other than (a) as disclosed in, set forth on, or reflected and adequately reserved against in the Balance Sheet, (b) those incurred in the Ordinary Course of Business since the Balance Sheet Date (none of which arises from or relates to any violation of Law, tort, breach of Contract, environmental, health or safety matter or infringement or violation of Law or misappropriation or is otherwise material), and (c) those Transaction Expenses, Indebtedness, Working Capital and unpaid credit card processor’s fees, costs and expense items fully included in the calculation of the Closing Payments.
The argument was that if the scheduled SSI debt was intended to be included in the Indebtedness that was a part of the Closing Date Indebtedness deducted in determining the Purchase Price, then there was no reason to schedule it as an Undisclosed Liability in the first place. Again, the Arbitrator made short work of this argument (even though I kind of liked it) by simply noting that disclosures against representations and warranties are often broader than strictly necessary, and they don’t override the actual defined terms for purposes of calculating the Purchase Price.
The Sellers also tried to argue that SSI was not an Operating Subsidiary as of the Adjustment Time because the spinoff was supposed to happen one business day before the closing, which would have been prior to 11:59 PM PT on March 27, 2022. But the actual spinoff occurred immediately prior to the closing, which by definition was after the Adjustment Time. And the Sellers conceded at the arbitration hearing that the SSI spinoff, “without a novation from [the SSI lenders,] would not by itself discharge Save Mart’s theoretical general partner liability” on the SSI debt. With that concession, the Arbitrator was able to conclude that even if the SSI debt was not Indebtedness of an Operating Subsidiary as of the Adjustment Time, it could still qualify as Indebtedness for which Save Mart was otherwise liable (as a former general partner presumably) pursuant to clause (xi) of the definition of Indebtedness. If the spinoff did not eliminate the risk of the SSI lenders pursuing claims against Save Mart for the SSI debt, the Buyer’s financing sources must have been concerned about ongoing creditors other than the known SSI debt. In other words, the risk of Save Mart having to answer for the SSI debt directly did not appear to have been a driving concern for the Buyer or its financing sources, and there was no reason to expect that getting the benefit of a credit of $109 million against the Purchase Price (and the resulting payment of approximately $70 million to the Buyer by the Sellers) was going to result in the Buyer using that money to actually pay the SSI debt.
The Sellers also sought to reform the EPA based on unilateral or mutual mistake. Unfortunately, to prevail on these arguments, the Sellers were required to show “that the parties came to a specific prior understanding that differed materially from the written agreement.” And in this case the Arbitrator found that:
Seller fails to support this critical element. It has not produced clear and convincing evidence of a pre-existing agreement between the parties to exclude the SSI Debt from the definition of Indebtedness. To be sure, Kingswood’s original letter of intent did not include any SSI Debt in its sample Indebtedness calculation. But there is no evidence, never mind clear and convincing evidence, that the sample Indebtedness calculation caused the parties to reach a “specific prior understanding that differed materially from the written agreement.” In fact, witnesses from both sides repeatedly testified that the two sides simply never discussed the treatment of the SSI Debt in the Acquisition. This mutual silence is a far cry from the sort of clear and convincing evidence that could support a claim for reformation based on a mistake. Delaware law is clear that claims for mistake are not supported by “poor contract drafting” and “cannot save a party from its agreement to unambiguous contract provisions that later prove disadvantageous.”
The Sellers also argued that the “forthright negotiator principle” should result in a finding in favor of the Sellers. Application of the forthright negotiator principle, however, requires that there be an ambiguity in the contractual language that cannot be resolved by extrinsic evidence that leads “to a single, commonly held understanding of the contract’s meaning,” the Arbitrator noted. In such cases, “the court, in considering alternative reasonable interpretations of contract language, [may] resort to evidence of what one side in fact believed the obligation to be, coupled with evidence showing that the other party knew or should have known of such belief.” But here, according to the Arbitrator, “Buyer’s alleged lack of forthright negotiation [is] irrelevant because the EPA is unambiguous.”
Following the issuance of the final arbitration award in favor of the Buyer, the Buyer immediately sought to confirm the award in the Delaware Court of Chancery. Vice Chancellor J. Travis Laster, on February 28, 2024, in SM Buyer LLC v. RMP Seller Holdings, LLC, 2024 WL 8652024 (Del. Ch. (Trial Order) Feb. 28, 2024), granted the Buyer’s motion for summary judgment confirming the final arbitration award. In his order, Vice Chancellor Laster noted that “review of an arbitration award is one of the narrowest standards of judicial review in all of American jurisprudence.” To do so based on “manifest disregard of the law,” which was the ground asserted by the Sellers, requires “that the arbitrator (1) knew of the relevant legal principle, (2) appreciated that this principle controlled the outcome of the disputed issue, and (3) nonetheless willfully flouted the governing law by refusing to apply it.” Applying this standard, Vice Chancellor Laster concluded that:
[T]he Arbitrator strictly applied the literal words of the definition of Closing Date Indebtedness. The Arbitrator analyzed the Agreement as a whole and interpreted its language consistent with recent trends in Delaware law towards a highly contractarian jurisprudence.
Given this record, it is not possible to find that the Arbitrator manifestly disregarded the law. He diligently applied the law.
But then Vice Chancellor Laster noted that even though he had to confirm the Arbitrator’s arbitration award in favor of the Buyer, he believed that “the outcome that the Buyer achieved in this case was . . . economically divorced from the intended transaction,” and that he “would have ruled differently than the Arbitrator” because:
I think the agreed-upon accounting principles and the mandate to prepare the reference statement and the final statement consistently meant that the Buyer’s adjustment was contrary to the plain meaning of the Agreement. At a minimum, I think the Agreement, read in conjunction with the Amendment and the separate treatment of the GP Interest [SSI], rendered the parties’ treatment of Closing Debt Indebtedness ambiguous.
Had the Sellers not agreed to submit this dispute to binding arbitration, they may still have had an appeal to the Delaware Supreme Court to right this apparent wrong, without the almost impossible burden of undoing the binding arbitration award. The appeal that is presumably in progress to the Delaware Supreme Court in the face of the final arbitration award is a much heavier lift than would have been the case had the final arbitration award simply been an opinion of the Delaware Court of Chancery.
This case raises some serious questions about deal-making ethics depending on who understood what and when about the potential inclusion of the SSI debt as a deduction to the Purchase Price. During my career I was once faced with a client pursuing a course of action that I believed was legally correct, but morally wrong, and my response was to refuse to represent them in the resulting dispute. Typically, sharp business practices will catch up with you eventually.
The obvious fix here, of course, was to amend the definition of Indebtedness to expressly exclude the SSI debt (and there were in fact a healthy list of exclusions to the definition of Indebtedness). That clearly should have happened. Another mitigating provision, which is often found in deals involving a private-equity-backed seller (which Save Mart was not), is to put a cap on any purchase price adjustment equal to the agreed escrow (which here was $7 million)—at least that would have resulted in a smaller ouch.
Deal lawyers tend to like Delaware’s strict contractarianism—it provides certainty that the documented deal is the deal. But that certainty can sometimes come at a cost in situations like this, particularly once an arbitrator applies that strict contractarianism.
