Buyer’s due diligence scuttles fraud claims

By Deborah Elkins
Published: January 12, 2009

An accountant who did his own due diligence before buying a Chesapeake accounting firm cannot blame the seller for the buyer’s failure to uncover issues he said led to the loss of the firm’s largest client.

The seller initiated suit on a $145,000 promissory note given in partial payment for the firm. The buyer counterclaimed for fraud, alleging problems with the firm’s computers and software hindered his attempts to discover the status of the firm’s clients and the value of its “work in progress,” for which the firm had been prepaid.

Norfolk U.S. District Judge Mark S. Davis granted summary judgment to the seller on the buyer’s fraud claims in White v. Nicholas L. Potocska P.C. (VLW 008-3-552) on Dec. 3. Still pending is the seller’s claim for over $200,000 in attorney’s fees and costs.

Under Virginia law, a person who makes his own investigation cannot say he relied on the representations of another, said Davis. He rejected the buyer’s effort to “carve out a new exception to this rule that would apply when one is unfamiliar with the computer application used by the company they seek to purchase.”

The seller Rock E. White listed the firm, Rock E. White & Associates, with business broker Leon Faris when White moved to Hawaii in 2005. The two other firm shareholders, Ali Gunbeyi and Evelyn Eidem, stayed on, with Gunbeyi acting as chief operating officer in the Chesapeake office and Eidem working remotely from Texas.

After Potocska tendered his first letter of intent in July 2006, he met with Gunbeyi and Eidem, and was provided with a computer work station in White’s old offices and a password for research in the firm’s records. Potocska, who signed a confidentiality agreement, was instructed to introduce himself to firm staff as a “possible investor” and “possible client.”

Potocska spent two days on-site at the firm. He apparently was unfamiliar with the “Creative Solutions” and “Practice Solutions” software used by the firm, and another firm accountant answered several of his questions about the computer. He also asked Gunbeyi for firm records.

Norfolk lawyer Mary Jane Hall, who represents White, filed an affidavit from Faris attesting to his involvement in approximately 1,000 sales of accounting practices over the past 25 years. Faris said Potocska “was one of the most diligent prospective buyers” he had worked with in many years.

The sale closed on Dec. 8, 2006, with a final purchase price of $768,566. The parties’ contract gave a credit of $123,566 for the work in progress the buyer would have to perform, with potential for an additional $25,000 credit for “WIP” discovered by May 31, 2007. The buyer paid $480,000 in cash and gave the $145,000 note payable solely to White.

Eidem left the firm a month after closing and took with her two Texas clients, companies owned by her personal friends in which Eidem had a 25-percent interest. Gunbeyi left in May 2007 to work for a former client of White & Associates.

Carpe Diem, the firm’s largest client, terminated the firm’s services 10 months after the sale closed because its prepaid year-end financials were not finished on time, according to Davis’s opinion.

White denied additional setoff and Potocska stopped paying on the note, leading to the litigation.

Davis said the buyer chose the method of due diligence – namely, using the computer in part and having the firm’s COO provide additional information at the buyer’s request.

“The law in Virginia is that a prospective purchaser who undertakes due diligence is charged with knowledge of everything that he could have learned by going through every piece of paper that was available to him,” Davis wrote. The fact that the buyer curtailed his investigation before he found all the “work in progress” did not suggest fraud by the seller.

Computer issues were no excuse, according to the court. Potocska could have pressed for more assistance, adjusted his offer or backed out of the deal. It was up to the buyer to ascertain the probability of clients continuing with the firm after its purchase.

And Potocska had no expert to back up his fraud claim based on the fact that two servers failed and the firm’s computer system crashed months after closing.

Davis also rejected Potocska’s contention that the confidentiality clause kept him from finding out which clients would continue with the firm, saying the buyer never asked permission to speak directly with clients.

The every-piece-of-paper rule puts the burden on the buyer to decide how much risk he wants to assume.

Tidewater business broker Stephen Stone, who was not involved in the White sale, said there are other ways to account for issues like client retention. For instance, the parties can negotiate an “earn-out” provision that lets the seller collect more money as clients continue with the business for a period of time. “It’s a win-win,” said Stone, “because the seller gets more if the business stays in. The pay-out is based on what you earn” as buyer.

Sometimes there simply isn’t the time or incentive to do exhaustive due diligence, according to Stone.

In the world of business buy-and-sell, only one out of four sales goes through, so you “can waste a whole lot of time” on due diligence. The important thing is to “make it clear to all the parties that we’re relying on what the seller tells us,” Stone said.

Norfolk lawyer Patrick H. O’Donnell also represents White. Chesapeake lawyer Thomas B. Kelly, who represented Potocska, could not be reached for comment.

Virginia Lawyers Weekly

Buyer’s due diligence scuttles fraud claims

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