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Watch out for Fraud in Family-Business Purchase Agreements

In business purchase agreements, including agreements between family members, the seller often retains pre-sale liabilities, such as tax liabilities, while the buyer assumes post-closing liabilities related to the business’ ongoing operations. But what happens when the buyer induces the seller to retain such liabilities through fraud? In Bailey v. Bailey, a U.S. District Court in Texas recently gave its answer when faced with a claim that a son defrauded his parents in connection with his purchase of the assets of their family-owned business.

According to the Court’s post-trial decision, Roger and Shirley Bailey owned an electrical services company. Their son, Jeffrey, had worked in the company for many years. In 2007, Roger and Shirley decided they no longer wanted to manage the company and put Jeffrey in charge. Shirley’s sole remaining responsibility was to control the cash disbursements from a bank account that she controlled as the company’s treasurer. In doing so, Shirley relied solely on requests for funding by the company’s bookkeeper.

By 2008, Jeffrey decided to buy the company from his parents. Jeffrey hired a CPA to organize the books in connection with the transaction. The CPA discovered that the company had failed to pay a “substantial” amount of payroll taxes for 2007 and 2008. When Jeffrey was informed of this unpaid tax liability, he told the CPA not to inform Roger or Shirley of it in connection with the sale. Jeffrey also instructed the company’s bookkeeper and CFO not to discuss the tax issue with his parents. Finally, Jeffrey himself did not say anything to his parents about the unpaid taxes.

The IRS also had sent two notices to Roger and Shirley notifying them of unfiled tax returns. Shirley informed Jeffrey about one of the notices and told him to take care of it. The Court found that Jeffrey, not Shirley, should have filed the returns, but that Jeffrey did not pay the payroll taxes at issue before the closing.

The sale closed in August 2008, with Jeffrey buying certain company assets and liabilities and Roger and Shirley retaining other assets and liabilities, including the company’s tax liabilities. Jeffrey then formed a new company with the assets he acquired. After the closing, the CPA wrote to Roger and Shirley to tell them about the unpaid payroll taxes.

Jeffrey, Roger and Shirley then became embroiled in litigation for over six years. One suit between them in Arkansas involved a claim that Roger and Shirley had improperly caused the company to borrow $500,000 right before the closing, thus increasing the debt Jeffrey would have to pay for the assumed liabilities. Jeffrey filed a second suit in Texas and sought an order that Roger and Shirley were responsible for the unpaid pre-closing taxes.

The Court noted that the company owed the IRS over $3,000,000 in unpaid payroll taxes and an additional trust fund penalty of more than $2,300,000. Shirley and Roger claimed that Jeffrey or his new company owed these taxes because Jeffrey withheld all information about the non-payment of taxes from them throughout the pre-sale period. They further claimed that had they known about Jeffrey’s failure to pay the company’s taxes, they would not have sold the company’s assets to him or would not have retained the tax liability.

The Court agreed and found that Jeffrey, as an officer of the company: (1) owed a fiduciary duty to the company and to his parents, as its owners, to disclose the company’s tax liabilities, (2) intentionally withheld the information so they would sell the assets to him at a “seriously false valuation,” and (3) thus fraudulently induced them to enter the asset purchase agreement. The Court also highlighted the mother and son relationship between Shirley and Jeffrey and found that Shirley, in particular, “trusted Jeffrey to take care of the company and to tell her about its problems” and yet Jeffrey “hid the truth from Shirley.”

Based on its finding of fraud, the Court entered an order that Jeffrey and his new company were responsible for the unpaid taxes and trust fund penalties, while Roger and Shirley were not responsible for either. This ruling is currently on appeal and it remains to be seen whether the judgment will be affirmed. Nonetheless, the decision serves as a reminder that a Court likely will not look favorably on a party’s attempt to enforce the terms of a business purchase agreement if that party induced the other party to enter the agreement through fraud.

In ruling in Shirley’s and Roger’s favor, the Court also rejected Jeffrey’s argument that he had no duty to disclose the unpaid taxes because, as treasurer, Shirley could have discovered the tax liability on her own if she had requested access to the financial records. Again, the Court determined that Jeffrey had a fiduciary duty to disclose the financial condition to Shirley and that the entries in the company’s books obscured the tax liabilities in any event.

In the end, the Court did not find that Shirley or Roger could have or should have done anything further to avoid being fraudulently induced into the asset purchase agreement. Instead, the Court found that their reliance on Jeffrey was “reasonable” under the circumstances. And while the Court ultimately provided Roger and Shirley a remedy against Jeffrey’s fraudulent conduct, this case also serves as a reminder that in family-business transactions, trust in other family members often (and unfortunately) is not enough to fully protect the parties’ rights. Instead, parties to family-business transactions may need to take additional steps to carry out the time-tested adage: “trust but verify.”

© Copyright 2020 Murtha CullinaNational Law Review, Volume VII, Number 40

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About this Author

Michael P. Connolly, Murtha Cullina, Shareholder Agreements Lawyer, Business Valuations Attorney
Partner

Michael Connolly is a partner in the firm's Litigation Department. He represents owners and managers of family-owned businesses and closely-held businesses in connection with disputes between business owners under LLC operating agreements, shareholder agreements, and partnership agreements; claims against directors and officers concerning company management and operations; and other internal disputes concerning business valuations, corporate distributions, and access to company information.

Mr. Connolly also has an active business litigation...

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