DATE: 20010809 DOCKET: C33179
COURT OF APPEAL FOR ONTARIO
OSBORNE A.C.J.O., LASKIN and FELDMAN JJ.A.
B E T W E E N :
Christopher Ashby
886496 ONTARIO INC. and
for the appellants
CPC PUMPS INTERNATIONAL INC.
Plaintiffs/Respondents
- and -
Michael Valente and
Matthew Molocci
YCI HOLDINGS INC., JOHN R.
for the respondents
YARNELL, DELOITTE & TOUCHE
(formerly known as DELOITTE
HASKINS & SELLS), ERNST & YOUNG
Defendants/Appellants
Heard: January 29, 2001
On appeal from the judgment of Justice William J. Festeryga dated November 4, 1999.
OSBORNE A.C.J.O.:
OVERVIEW
[1] This appeal arises out of a dispute over the final purchase price of shares in United Pumps of Canada Limited. On July 17, 1990 the respondent, 886496 Ontario Inc. (“the purchaser”), agreed to purchase all of the shares of United Pumps of Canada Limited (Pumps). Pumps is now known CPC Pumps International Inc. Pumps manufactures centrifugal pumps, primarily for the oil and gas industries. The vendor was Quorum Industries Inc., now known as YCI Holdings Inc. (YCI). The appellant, John Yarnell, through holding companies, controlled Quorum. I will refer to Quorum (and YCI) as the vendor.
[2] The share purchase and sale agreement (the agreement) provided that the purchase price would be Pumps’ shareholders equity, less the book value of the goodwill, in accordance with Pumps’ May 31, 1990 financial statements. This was referred to in the agreement as the “estimated purchase price”. The agreement also provided a means to determine Pumps’ shareholders’ equity as of the date of closing, July 19, 1990. This was referred to in the agreement as the “final purchase price”. The final purchase price was to be based on Pumps’ July 19, 1990 (date of closing) financial statements. Thus, under the agreement, in order to establish the estimated and final purchase prices, the vendor and the purchaser were required to determine the value of Pumps’ assets and liabilities as of May 31, 1990 and July 19, 1990. As the deal unfolded, the value of Pumps’ inventory became the central area of dispute for purposes of establishing the final purchase price.
[3] The value of Pumps’ inventory was also the central issue around which the purchaser’s damages for breach of contract and negligent misrepresentation were found by the trial judge. In normal circumstances, one might expect the purchaser to pay the vendor for Pumps’ shares since Pumps was an operating company which usually generated a profit. However, after a 12-day trial without a jury, the trial judge found that Pumps’ inventory was overvalued. He concluded that Pumps’ shareholder’s equity, net of goodwill, was zero and that the purchaser should pay nothing to buy Pumps shares.
[4] In determining what the final purchase price should have been, the trial judge concluded that Pumps’ inventory, valued at $1,654,356 for purposes of calculating the estimated purchase price for Pumps’ shares, was overvalued by $527,159. He thus reduced the purchase price by $527,159. In the end, based on a calculation I will review later in these reasons, the trial judge found that not only should the purchaser pay nothing for the shares, but that the vendor should pay the purchaser $19,258 to buy the vendor’s shares. He tempered that finding by concluding that the vendor should simply repay the purchaser what it had paid for Pumps’ shares on closing. That meant that the vendor got, and the purchaser paid, nothing for the shares. The vendor and its principals contend that this was not what they had in mind when they agreed to sell Pumps’ shares. They also contend that the result does not accord with the provisions of the agreement.
[5] The vendor’s appeal raises, inter alia, the following issues:
• Under the agreement was the vendor liable to the purchaser on the basis of any of the pleaded causes of action asserted by the purchaser?
• Did the trial judge correctly assess the purchaser’s damages?
• Did the trial judge err in finding that the appellant John Yarnell was liable for all of the assessed damages?
[6] To deal with these issues, some reference to the evidence, including the provisions of the share purchase agreement, is required.
The Evidence
[7] In early 1990 the purchaser’s principals, John Weitner and Manfred Blumentrath, learned that the vendor, which owned all of Pumps’ shares, was interested in selling those shares. For a number of years, with the exception of the year ending January 31, 1988, Pumps had been a profitable operating company. Deloitte & Touche, Pumps’ auditors at all material times, produced Pumps’ audited financial statements for Pumps’ January 31st year end in the years 1989 and 1990.
[8] Weitner and Blumentrath expressed an interest in buying Pumps’ shares. They toured Pumps’ plant in March 1990. On May 3, 1990, they signed a letter of intent to buy Pumps’ shares. The letter was accepted by the vendor on May 4, 1990. At that time, Pumps’ audited financial statements for its January 31, 1990 year end were not available. The purchaser paid a deposit of $15,000 at the time of the signing of the letter of intent. The deposit was to be credited to the purchase price.
The Agreement
[9] On July 17, 1990 the vendor, the purchaser and Pumps signed a share purchase and sale agreement. Article 2.01 of the agreement provided that on July 19, 1990, the stipulated closing date, the purchaser would buy and the vendor would sell all of Pumps’ shares for a price equal to Pumps’ shareholders’ equity, less goodwill, based on Pumps’ financial statements for the financial period February 1, 1990 to the date of closing, July 19, 1990.
[10] By Article 2.01(1)(b) of the agreement, the purchaser agreed to provide an “earn-out promissory note” payable to the vendor. Under that note, the purchaser became potentially liable to the vendor to a maximum of $300,000 based on a stipulated percentage of Pumps’ collected invoices in excess of $3,000,000 in each of the five years following the closing of the agreement. The specific terms of the earn-out promissory note are set out in Article 2.01(1)(b) of the agreement. The purchaser acknowledges that Pumps’ collected invoices in the relevant time frame triggered its liability to pay the vendor the maximum $300,000 on the earn-out promissory note. This was the subject matter of the vendor’s counterclaim. The purchaser did not pay on the earn-out promissory note because of its dispute with the vendor concerning the appropriate final purchase price.
(a) The estimated purchase price
[11] Since Pumps’ July 19, 1990 financial statements were not available at closing, the agreement provided for an “estimated” purchase price. It was based on Pumps’ May 31, 1990 balance sheet which was prepared by Robert Yarnell, the respondent John Yarnell’s son. The calculation of the estimated purchase price, that is, the purchase price payable on closing, was provided for in Article 2.02 of the agreement. Article 2.02(2) provided that the calculation was to be based on Pumps’ May 31 interim financial statement:
2.02(2) The estimated purchase price payable under s. 2.02 shall be based on the interim financial statement of the corporation as at May 31, 1990, with such adjustments as shall be agreed upon by the Vendor and Purchaser, acting reasonably, at the Closing Date, as a result of the inventory count referred to in subsection 2.04(1). The outstanding balance to be evidenced by the Purchase Promissory Note pursuant to paragraph 2.02(1)(c) shall be estimated by the Vendor and Purchaser, acting reasonably, at the Closing Date and shall be amended or cancelled immediately following the completion of the Acquisition Review.
[12] Read together, Articles 2.02(2) and 2.02(1)(c) provide that any excess over $500,000 was to be accounted for by a purchase promissory note:
2.02(1)(c) a non-assignable promissory note of the Purchaser in an amount equal to the Corporation’s Shareholder Equity, less the book value of goodwill, less the sum of FIVE HUNDRED THOUSAND ($500,000.00) DOLLARS (the said promissory note being referred to hereafter as the “Purchase Promissory Note”). The outstanding balance of the Purchase Promissory Note shall bear interest at the prime lending rate of The Royal Bank of Canada as determined from time to time plus one (1%) per cent per annum. The principal shall be repayable in three equal annual instalments, with the first payment commencing one year following the Closing Date. Interest shall be calculated and payable semi-annually, using the average of the said prime lending rate over the previous six months for the said interest calculations. The Purchaser shall have the right to pay all or part of the principal outstanding from time to time without notice or bonus;
[13] The purchase promissory note was to be amended or cancelled following the purchaser’s receipt of Pumps’ July 19, 1990 change of control (date of closing) financial statements and completion of what the agreement referred to as the Acquisition Review. I will refer to the Acquisition Review when I deal with the final purchase price.
[14] Just as Articles 2.02(2) and 2.02(1)(c) of the agreement provided for a purchase price greater than $500,000, Article 2.02(3) of the agreement provided for a purchase price less than $500,000:
2.02(3) To the extent that the Corporation’s Shareholders’ Equity less the book value of goodwill is less than FIVE HUNDRED THOUSAND ($500,000) DOLLLARS, then the Vendor shall repay the difference to the Purchaser, together with interest at The Royal Bank of Canada’s prime lending rate as determined, from time to time, plus one (1%) per cent, not to exceed seventeen (17%) per cent per annum. Payment of the same shall be immediately due and payable upon the determination of the same.
[15] Clearly, Article 2.02(3) of the agreement required the vendor to repay part of the estimated purchase price if Pumps’ shareholders’ equity, net of goodwill, was less than $500,000. I very much doubt that the purchaser’s principals fully understood the implications of this part of the agreement.
(b) The final purchase price
[16] Article 4.02(6) of the agreement set out the means by which the final purchase price was to be determined:
4.02(6) The Vendor, at its own expense, shall prepare the “change of control” financial statements as at the Closing Date for the Corporation within forty-five (45) days of the Closing Date for review by the Auditors pursuant to the Acquisition Review. Upon agreement by the Auditors and the Corporation’s Accountants as to the said financial statements, the Purchase Promissory Note provided for in paragraph 2.02(1)(c) shall be amended to reflect the amount due under the calculation of the Purchase Price pursuant to subsection 2.02(2) or cancelled subject to the terms of subsection 2.02(3) herein, as the case may be. Failing agreement between the Auditors and the Corporation’s Accountants, the matter shall be referred to arbitration pursuant to subsection 6.05.
[17] According to Article 4.02(6), the vendor was required to prepare change of control financial statements to reflect Pumps’ financial position as at July 19, 1990, the date of closing. The vendor agreed to provide the change of control financial statements within 45 days of the closing date, that is, by September 3, 1990. The change of control financial statements were to be reviewed by the purchaser’s accountants as part of the Acquisition Review which was intended to determine the final purchase price. If the accountants for the purchaser and the vendor agreed on the final purchase price, the purchase promissory note was to be amended or cancelled, depending on whether the final purchase price was more or less than $500,000. If no agreement could be reached, the agreement provided that the issue of the final purchase price was to be arbitrated.
[18] The Acquisition Review was defined in the agreement to mean the purchaser’s due diligence review by its accountants, Cooper & Lybrand. The review was to be paid for by the purchaser, as was the cost of taking inventory. It was to be completed within 30 days of the purchaser’s receipt of the change of control financial statements, which, as I have said, were to be provided within 45 days of the closing date. Thus, the Acquisition Review was to be completed by early October 1990, at the latest.
(c) Inventory
[19] Article 2.04 of the agreement specifically dealt with inventory. [^1] This article provided:
2.04 In order to determine the value of inventory for purposes of the determination of the Corporation’s Shareholders Equity pursuant to paragraph 2.01(1)(a) and section 2.02, on the 17th and 18th day of July, 1990, representatives of the Purchaser and the Auditors, in the presence of representatives of the Vendor, shall:
(a) make a determination of the saleable inventory of the Corporation, in the sole discretion of the purchaser, acting reasonably; and
(b) take a physical counting of the saleable inventory determined pursuant to paragraph 2.04(1)(a), which inventory shall be priced as determined by the Purchaser and Vendor, acting reasonably, consistent with the Financial Statements.
[20] As it turned out, the inventory count contemplated by Article 2.04 took place on July 14, 1990, not on July 17 and 18, 1990. On July 14th, the purchaser determined what Pumps’ saleable inventory was (Article 2.04(a)) and took a physical count of the saleable inventory (Article 2.04(b)).
[21] The Financial Statements referred to in Article 2.04(b) were defined in the agreement to mean Pumps’ audited January 31, 1990 financial statements. Article 2.04(b) contemplated that the purchaser and its accountants, in the presence of the vendor’s representatives, would determine and count Pumps’ saleable inventory and that the inventory be priced in a manner consistent with Pumps’ audited January 31st financial statements. Article 2.04(b) is not clear as to when the purchaser would value Pumps’ saleable inventory. As I will explain later in these reasons, by their conduct both the vendor and purchaser seem to have proceeded on the premise that the agreement required the purchaser to determine and count Pumps’ saleable inventory before closing, but establish the value of the saleable inventory after closing. Thus, the purchaser did not attempt to value or price the inventory on July 14, 1990. It did that after closing.
[22] Pumps’ January 31, 1990 audited financial statements are significant because the agreement provided that the financial statements on which the estimated and final purchase prices were to be prepared in accordance with “generally accepted accounting principles on a basis consistent with the audited financial statements as at January 31, 1990”. Thus, Pumps’ January 31st audited financial statements were something of a model.
(d) The Closing
[23] The deal closed on July 19, 1990. At that time, the principals of the purchaser and the vendor, and their solicitors, met in the purchaser’s solicitors’ office. The purchase price for the purpose of the July 19th closing, as I have said, was to be based upon Pumps’ unaudited May 31, 1990 financial statements. Those statements showed total assets of $2,784.514, goodwill of $136,152 and total liabilities of $2,042,984. The difference between Pumps’ total assets, less goodwill, and its total liabilities was $605,378. This became the estimated purchase price for purposes of closing the deal on July 19, 1990.
[24] Going into the closing, the purchaser had expressed concern about the value of Pumps’ inventory. On July 17, 1990, two days before closing, the purchaser’s solicitors wrote to the vendor’s solicitors on a number of subjects. One of them was the saleable inventory which had been counted, but not valued, on July 14, 1990. The letter stated:
… Further, upon a review by our client on the weekend of the inventory, it appears to fall far short of the amount previously set out in the audited financial statements. Accordingly, our client is reasonably requesting that $100,000 of the amount due and payable on the closing date be held in escrow [sic] pending the completion of the acquisition review. Following the same, the purchase money shall be dispersed to the vendor or purchaser following the correct determination of the corporation’s shareholders’ equity, less goodwill, as at the closing date.
[25] The purchaser’s concern about the value of Pumps’ inventory was raised again at the closing. Although the evidence is not entirely clear as to precisely what happened at this time, it would appear that one of the parties, presumably the purchaser, threatened to walk away from the deal. In the result, Yarnell and Blumentrath, representatives of the vendor and purchaser respectively, left the room to see if they could resolve the purchaser’s concerns about the value of Pumps’ inventory. What happened at their meeting requires brief reference to their evidence.
[26] Yarnell said that at the time of closing, the issue of saleable inventory was raised in the context of the purchaser’s conclusion that Pumps’ saleable inventory was overvalued by approximately $100,000 because that much of it was obsolete. Yarnell went on to testify:
There was considerable discussion on the matter and we didn’t seem to be making any effective resolution and I asked Mr. Blumentrath to step out of the meeting room with me and we went to an adjoining room, and in our discussions agreed to resolve these issues by the vendors doing two things, agreeing to the purchase promissory note which premised on the May 31 statements would have had a face value of approximately $100,000 to $105,000, that it would be nil. And secondly, Quorum Industries supported by my personal guarantee would support a further $100,000 of questionable saleable inventory.
Q. So on the basis of these two items was there an agreement to proceed to closing?
A. Yes. In my judgment, inventory matters had been dealt with in the negotiations that took place at closing.
[27] In his evidence, Blumentrath did not comment specifically on the closing arrangements which led to the cancellation of the $105,378 purchase promissory note and the delivery to the purchaser of Yarnell’s $100,000 personal guarantee. Blumentrath recognized that inventory was the largest component of Pumps’ assets. He knew that after closing “… there would be a plus or minus on the selling price based on the inventory”. He clearly assumed that the purchaser would value Pumps’ inventory after closing. In his examination-in-chief he was not asked about the specific arrangements, which were later referred to in Yarnell’s evidence, made at the closing. In his cross-examination, Blumentrath was not asked about the closing arrangements he made with Yarnell. He did not give evidence in reply. Thus, Blumentrath’s evidence does not deal directly with Yarnell’s evidence that at the closing he and Blumentrath made a side deal, as representatives of the vendor and purchaser, the effect of which was to resolve the inventory issue once and for all.
[28] Whatever the scope of the Yarnell-Blumentrath arrangements was, it is clear from their evidence that at the time of closing, the purchase promissory note of $105,378 was cancelled and Yarnell provided his personal guarantee of $100,000. Neither the cancellation of the purchase promissory note at closing, nor the provision of Yarnell’s $100,000 guarantee, was contemplated by the agreement. Specifically, the agreement said nothing about a guarantee to be provided by anyone, including Yarnell. Further, although the agreement provided for the amendment or cancellation of the purchase promissory note, those steps were to be taken, if at all, after the vendor provided Pumps’ July 19, 1990 financial statements (the change of control financial statements) and after the purchaser completed its Acquisition Review. While there is much that is unclear about the closing arrangements in respect of the purchase promissory note and Yarnell’s guarantee, it is clear that at the very least, the purchase promissory note was cancelled and Yarnell provided his guarantee because of the purchaser’s concerns about the value of Pumps’ inventory. Indeed, once the purchaser secured the cancellation of the purchase promissory note and acquired Yarnell’s personal guarantee for $100,000, the deal closed.
(e) Representations and Warranties
[29] The agreement contained a number of representations and warranties. I see no need to review them in any detail. It will suffice to note that the purchaser relies on two of the vendor’s representations. First, that Pumps kept its books and records in conformity with generally accepted accounting principles; and second, that Pumps did not withhold any material information in its possession pertaining to Pumps’ assets (including inventory), liabilities, business and operations. Article 3.02 of the agreement provided that all of the vendor’s representations and warranties would survive the completion of the sale. Article 4.02(3) provided that the vendor indemnify and save harmless the purchaser from and against all losses, damages or expenses sustained by the purchaser resulting from any breach of any covenant of the vendor.
[30] At the trial, the purchaser led evidence and submitted that Pumps’ January 31, 1990 financial statements were not prepared in accordance with generally accepted accounting principles. The trial judge found that the inventory as set out in the vendor’s audited January 31, 1990 financial statements was “consistently misstated in the subsequent statements of May and July of 1990”. He concluded that the auditors, Deloitte, Touche, relied too heavily on representations made by the vendor with respect to the inventory, particularly in respect of the labour component (the hours spent) of the vendor’s work in process. In the end, he agreed with the purchaser and concluded that Pumps’ January 31, 1990 financial statement was not prepared in accordance with generally accepted accounting principles. Since Pumps’ financial statements of May 31, 1990 and July 19, 1990 were consistent with its January 31, 1990 financial statement, it followed that the May and July financial statements were also not prepared in accordance with generally accepted accounting principles.
[60] The trial judge correctly used Pumps’ July 19, 1990 balance sheet to determine Pumps’ shareholders’ equity, that is the appropriate final purchase price for Pumps’ shares. The total assets in accordance with that balance sheet were $2,481,996. The corrected total after deducting the overvaluation of Pumps’ inventory in accordance with the trial judge’s findings, subject to the obsolete inventory adjustment referred to above, is $1,970,215.47. Pumps’ total liabilities were $1,839.625. The difference between Pumps’ total assets, as adjusted, and Pumps’ total liabilities is $130,590.47. To get to the final purchase price as prescribed in the agreement, goodwill must be deducted. The goodwill listed on Pumps’ July 19, 1990 balance sheet is $134,470. Deducting goodwill leads to a negative purchase price of ($3,879.53). The trial judge rounded the final purchase price down to zero, I assume on the premise that the parties did not contemplate that the vendor would pay the purchaser to buy Pumps’ shares. I see no reason to adopt a different approach. Neither parties’ reasonable expectations contemplated a negative purchase price.
[61] The trial judge moved from a determination of what Pumps’ shareholder’s equity, net of goodwill, should have been to the consideration of what the vendor should repay the purchaser because of the substantial inventory adjustment. He correctly proceeded on the premise that the purchaser had paid $500,000 to buy Pumps’ shares.
Conclusion
[62] The purchaser’s damages quite properly reflect what it should have paid for Pumps’ share had the inventory been valued in a manner consistent with generally accepted accounting principles. I thus have no difficulty with the approach followed by the trial judge in determining what the purchaser’s loss was. However, I think that the trial judge erred in not recognizing that this was an action for damages, not an action to determine what the purchase price should be as if the deal was to close immediately following the release of the judgment. In my opinion, it follows that the benefits that accrued to the purchaser as a result of the inflated estimated closing purchase price, caused by the vendor’s misrepresentations as to the value of Pumps’ inventory, should take into account the $150,000 that the purchasers received from Deloitte & Touche and the $175,000 tax benefit that resulted directly from the inventory write down.
[63] With the adjustment I have set out above regarding the value of Pumps’ obsolete inventory, the adjusted inventory write down is $511,781.53. From that gross write down the following should be deducted:
• tax benefit received as a result of the inventory write down:
$175,000
• proceeds of the Deloitte & Touche settlement:
$150,000
$325.000
[64] The purchaser’s net – and compensable – loss is the difference between its gross inventory write down, $511,781, and the deductions which total $325,000, that is $186,781. The purchaser is entitled to judgment in that amount against the vendor. The purchaser is also entitled to prejudgment interest. I am confident that counsel can work out the interest calculations.
[65] Subject to set off, John Yarnell’s personal exposure, including prejudgment interest, should be limited to a maximum of $100,000, the amount of the personal guarantee he signed on closing and the amount for which he was sued.
[66] The purchaser’s obligation under the earnout promissory note is a separate matter. Judgment should issue in favour of the vendor on its counterclaim for $300,000 on that note. The formal trial judgment provided that the purchaser’s obligation under the earn-out promissory note of $300,000 be cancelled and discharged since, on the trial judge’s findings, the vendor owed the purchaser more than the $300,000 that the purchaser owed the vendor on the earn out promissory note. The judgment should be varied to reflect the purchaser’s obligation to pay the vendor $300,000 on the earn out promissory note since the vendor’s net obligation to the purchaser caused by the inventory adjustment is less than what is owing on the earn out promissory note. The vendor is entitled to interest on the $300,000 earn out promissory note. The $186,781 that the vendor owes the purchaser should be set off against the purchaser’s earn out promissory note obligation of $300,000. When that is done, Yarnell’s contingent liability on his guarantee disappears. Accordingly, the purchaser’s action against Yarnell should be dismissed.
[67] The vendor and Yarnell, who were represented by the same counsel, have achieved substantial success on this appeal and are entitled to the costs of their appeal. I would ask counsel to make any submissions they wish to make with respect to the costs of the trial within the next 15 days. The trial judge’s supplementary reasons referred to a settlement offer made by the purchaser on November 12, 1998 as being more favourable to the vendor than the judgment. The trial judge thus ordered the vendor to pay the purchaser’s solicitor and client costs after November 12, 1998. This offer, and perhaps other offers, may affect the disposition of costs of the trial. If there are settlement offers which may affect the disposition of the trial costs, counsel should provide us with particulars of those offers in their submissions.
[68] I would allow the vendor’s and Yarnell’s appeal and vary the trial judgment in accordance with these reasons.
“C.A. Osborne A.C.J.O.”
“I agree: J.I. Laskin J.A.”
“I agree: K. Feldman J.A.”
RELEASED: August 9, 2001
[^1]: Inventory was singled out for separate treatment in the agreement. The only other asset that was singled out was Pumps’ accounts receivable. Article 4.02(9) of the agreement provided that there would be a post closing adjustment following the closing date if any of Pumps’ receivables were not collected by the purchaser within 120 days after July 19, 1990. In the event that there was a shortfall, Article 4.02(9) provided that the shortfall be set off against the purchase promissory note which I discussed in connection with the agreement’s estimated purchase price provisions.
[^2]: On March 8, 1994, Marshall J. dismissed a motion to stay this action, pending completion of the arbitration. It was alleged that there was no failure to agree that would trigger the arbitration provided for in the agreement. Neither party submits that their dispute should have been arbitrated. Accordingly, I will say no more on that subject.