In Western Pharmacy (“Plaintiff”) v. Park Medical et al. (“Respondents”), the Arbitration Tribunal made the final decision in favor of Plaintiff on March 28, 2022. The Tribunal has ruled that the defendants – the sellers of a chain of pharmacies – committed a careless misrepresentation towards the claimant – the buyer. The Arbitration Court calculated the damage with the same EBITDA multiple that Plaintiff used to calculate the purchase price for the pharmacies.
The dispute was governed by California law. The Award is available on Jus Mundi.
Actual Background (Simplified)
The dispute related to a leveraged buyout transaction in 2017 in which Plaintiff purchased seven pharmacies from Defendants for the price of $25 million. For the calculation of the purchase price, the plaintiff relied on the annual accounts prepared by the defendants. Plaintiff has calculated the purchase price on an EBITDA multiple of 6.05 plus inventory and accounts receivable.
What Plaintiff did not know when she bought the pharmacies was the following: in the past, the Defendant’s management used so-called Cardinal Inventory Management reports when drawing up the inventory in the annual accounts. In the fourth quarter of 2016, respondents’ management realized that the values from the Cardinal Inventory Management reports were incorrect and could no longer be used. Respondent management used estimated inventory numbers and adjusted the assets on the balance sheet. In the first quarter of 2017, respondents’ management also had difficulty determining accounts receivable and had to estimate and further adjust assets on the balance sheet. Defendants’ management did not inform Plaintiff that the financial reporting of inventories and accounts receivable had been incorrect and unreliable.
The plaintiff relied on the restated financial statements, which were justified in the Asset Purchase Agreement as true and correct. The final price of $25 million was a multiple of 6.05 times the incorrect EBITDA, which is $4.133 million. Respondents were aware that 2017 EBITDA would have been $3.1 million without the inventory and accounts receivable adjustments, but did not disclose this to the plaintiff.
Plaintiff filed claims for fraud against defendants on the grounds that defendants misrepresented the EBITDA, on which Plaintiff relied for the calculation of the purchase price.
The decision of the arbitral tribunal
The court held that the defendant had misrepresented the facts. Interestingly, the Tribunal concluded that the financial statements prepared by Defendants’ management conform to generally accepted accounting principles (“GAAP”), but that the misrepresentation resulted from “don’t tell the whole story“:
“Knowing to what extent the buyers relied on accurate financial information, it was the duty of the respondents to speak fully when providing information about Park Medical, and they failed to do so. Respondents did not tell Messrs. Grayson and Faris that there were difficulties distinguishing between inventories and receivables in the fourth quarter of 2016 and the first four months of 2017. The financial statements generated for those periods include management estimates, and there is no evidence that this has ever been necessary. I do recognize that generally accepted accounting principles allow reasonable accounting estimates by management if there is documentation to support the assumptions underlying the accounting estimates. But when business disruptions require management to use modified source data to generate financial statements, such a change in accounting practice is material information that must be shared with readers to whom those reports are given.
I find it inescapable that every bit of financial information provided to the buyers showed an ever-improving business (see eg Ex. 3, pp. 332451-332474). There was every reason for Messrs. Grayson and Faris to believe that they were acquiring an emerging company – one that would provide a solid platform from which to grow the operation into the ‘next plateaus’.
[…] The question is not whether the December 2016 and 30 June 2017 financial statements are accurate or in accordance with generally accepted accounting principles. The problem is that those statements don’t tell the whole story
[…] Failure to disclose the failure in the financial systems made the profit and loss account a ‘half truth’.“.
According to the Tribunal, it was a combination of three facts that led the Tribunal to misrepresent the facts: (i) Defendants knew that Plaintiff was relying on the financial statements, (ii) a dramatic change in accounting practice is material information for a buyer, and (iii) the financial statements provided to the claimant depicted a growing business.
On a quantum basis, the Arbitration Court determined the damage based on the deficit of the EBITDA times the EBITDA multiple:
“The measure of damages in a California fraud claim is the difference between the “true value of what the defrauded person parted with and the actual value of what he received” (Civ. Code Section 3343(a); see CACI 1923 ).
[…] The most important fact in my rating of the seven pharmacy stores is the candid, casual statements of Messrs. Robins and Grasela. Theirs is the best proof. No doubt their comments on the $3.1 million EBITDA were intended to be a best estimate rather than an accurate calculation, but these estimates are the closest to objective truth. If their best estimate had been $200,000 to $400,000 more, I would have expected them to say so.
[…] The obscurity of Park Medical’s financial statements leads me to conclude that Messrs. Grasela and Robins’ candid assessments are the most reliable valuation. A multiple of 6.05 times an EBITDA of $3.1 million is the most reasonable method of valuing Park Medical. EBITDA of $3.1 million proves the true value of the company as $18,755,000, plus inventory and receivables. Plaintiff paid $25 million plus, and damages are $6,245 million.“
It is not clear from the judgment whether the multiple of 6.05 was disclosed to the Defendants, or whether the Parties calculated both with such a multiple, or whether the Arbitration Court arrived at the multiple by calculating back.
As a result, the Tribunal awarded $6,245 million in damages for the overpaid purchase price/difference between the price Plaintiff paid and the value Plaintiff received.
Content is provided for educational and informational purposes only and is not intended and should not be construed as legal advice. This may qualify as “Lawyer Ads” requiring notice in some jurisdictions. Previous results do not guarantee comparable results. For more information, visit: www.bakermckenzie.com/en/client-resource-disclaimer.