To: Professor Ainsworth
From: Kevin Cassidy
Re: ABRY Partners V, L.P. v. F & W Acquisition LLC

Background
The ABRY case brought forth the circumstances in which a seller may contractually protect itself in a purchase agreement from claims by a buyer for rescission and post-closing damages due to intentional misrepresentations concerning the business or assets being sold.
F & W Publications (F&W) is the operating company whose ownership was the key asset effectively sold in the Stock Purchase Agreement. F&W was a publishing company that published special interest magazines and books both in the United States and internationally.
Providence Equity Partners (Seller) is a sophisticated private equity firm that specializes in communications and media companies and is the owner of F&W.
ABRY Partners (Buyer) is a sophisticated media-focused private equity firm that currently owns several media companies throughout the United States.
In the ABRY Partners case, Buyer attempted to rescind, several months after the closing, its $500 million purchase of F&W from Seller. Shortly following the transaction’s closing, Buyer began to identify a number of serious financial and operational problems that let Buyer to conclude that it had been defrauded by the Seller and F&W. Buyer alleged that Seller and F&W’s management manipulated F&W’s financial statements in order to fraudulently induce Buyer to purchase F&W’s at an excessive price. Buyer claimed that because of these manipulations, F&W’s historical financial statements contained material misrepresentations and did not accurately depict F&W’s financial condition, which constituted a breach of F&W’s representations and warranties. Finally, Buyer alleged that the failure to implement technological systems and the lack of notification of these problems in an officers “bring-down” certificate delivered by Seller constitutes a breach to the Purchase Agreement.
The Purchase Agreement contained numerous provisions that represent Buyer’s reliance on the accuracy of Seller’s financial statements, these provisions which are at the center of this case include: * Non-Reliance Provision- the Buyer’s promise that it would not rely upon any representations and warranties not contained in the Purchase Agreement and that none had been made, and that neither the Seller nor F&W would be liable for any extra-contractual representations and warranties, data rooms, and management presentations or discussions prior to signing. Contained within this provision was a very broad integration clause. * Indemnity- which limits the Seller’s liability for claims by the Buyer for breach of representations, warranties, or covenants in the Purchase Agreement. Also included was a monetary cap of $20 million or 4% of the $500 million purchase price. * Exclusive Remedy Provision- this entailed that Indemnity Claims were o be the sole and exclusive remedy for the parties with respect to the transaction.
The Delaware Chancery Court found that a contract between sophisticated parties would be upheld if it contains a provision that explicitly denies reliance upon representations outside of a contract. The court noted that if it failed to enforce such provisions, it would create a “double liar” scenario. Meaning if the court allowed the Buyer to prevail on its fraud claim, it is effectively authorizing Buyer’s own fraudulent conduct; Buyers assertion in a written contract that it was not relying on extra-contractual representations. The court ruled that Seller’s liabilities would be limited to the $20 million cap, provided it did not lie. However, in accordance with Delaware’s public policy, would not permit the enforcement of a contractual provision limiting the Buyer’s remedy to a capped damages claim. Thus, if Buyer could prove Seller knowingly misled it, either because (1) Seller knew that F&W’s contractual representations and warranties were false, or (2) that Seller itself lied to Buyer about a representation and warranty, then Buyer could collect damages in excess of the indemnification cap or possibly have the deal rescinded.
Concerns to be addressed in Due Diligence
Buyer claimed that F&W overstated magazine revenues through ‘Backstarting,’ which enabled F&W to report income earlier by using up more of a subscription in the first month. Additionally, Buyer claimed that F&W used outdated estimates to reflect newsstand revenues and intentionally reduced “book return” reserves to increase reported earnings. Buyer also accused F&W of ‘channel stuffing’ in which they deliberately sent retailers more products than they are able to sell. Seller also, to increase revenues and earnings, extended the quarterly reporting period of their UK subsidiary; shipped magazines in June that were scheduled for July, to report revenue in June; moved their book club cycle to reflect second half numbers for 2005; and reported revenues related to a conference held in June without reporting the expenses incurred. All together, F&W allegedly made the quarter ending in June look artificially better by shorting later financial periods.
Looking into the financial statements of F&W is most clearly the first and most oblivious endeavor that must take place during the due diligence process. Buyer’s offer was largely based on Seller’s free cash flow measured by its EBITA. Buyer’s offer was made on the basis of 10xEBITA for 12 months ending in June 30, 2005. Seller’s management made a clear point to show that the EBITA of $51 million was going to be projected. Post-closing, Buyer realized December 2004, March 2005, and June 2005 financial statements contained material misrepresentations. Why did they not investigate?
Buyer and Seller are both apart of the same industry, thus they should know what implications that the business entails. ‘Backstarting’ and ‘channel stuffing’ are not rare in the media business, especially when it comes to magazine subscriptions and sales. Buyer should have looked into the Purchase Orders of the Seller and what subscribers the magazines were going to. It might seem much, but identifying the subscription procedures of the Seller could help identify misrepresentation. Backstarting happens when a customer makes a subscription in July and receives back magazines from the New Year, essentially making their subscription January-June. Buyer should have known to look into the subscriber base and see how many magazines were delivered that did not reflect the month that they were sent.
Buyer’s role serves the same purpose as that of Seller and thus understands the processes in reporting actual numbers to reflect newsstand revenues and processing book returns correctly to reflect financial stability. It seems like a regular business practice that publishers have a tendency to exasperate retail channels to support sales and earnings figures. Buyer would have been wise to look into the retail channel of Seller, identify retail channels, and investigate their figures in comparison with Seller’s numbers. I know that it sounds like a lot of work, but the sales from newsstands are an essential part of F&W’s revenues, and the return of not sold issues is also crucial to the turnover ratio’s that determine the success of the Seller. Therefore sourcing information that looks into the delivery of products to newsstands and retail outlets is essential while also looking into the sales of materials from those outlets from Seller is wise.
Looking into the delivery of materials to newsstands and retail outlets will help Buyer understand what obsolete inventory and uncollectable accounts receivable are represented in the financial statements of the Seller. Both Seller and Buyer are sophisticated PE firms, who understand the industry that they work in; Buyer should have had the wits to look into the delivery of materials to outlets and follow up on the sales from those outlets. The return process seems to be an important pinpoint in the industry, thus the follow up on purchase orders would enable Buyer to estimate the return rate on magazines and determine the true revenue from deliverables. Focusing on the returns of magazines would enable Buyer to understand if Seller was participating in channel stuffing or back starting and therefore the ability to address the reality of their financial statements.
The financial statements for June 2005 have been a big question in this case. Buyer in their diligence process should have recognized the revenues and expenses set aside for Seller’s book club and conference because it seems like a regular course of business for Seller. Further, the diligence into the subsidiaries of the Seller should have been done. Identifying the reporting processes for the book club, conferences, and subsidiaries would help identify misrepresentations in Seller financial statements. That goes with all of Seller’s reporting, if Buyer made a point to understand the intricacies of Seller’s business then they would have been able to identify trends of the misrepresentations they claimed.
It is reverse engineering when looking to the EBITA of a company and identifying the importance of revenues in light of expenses. Buyer should have contacted managers in respective divisions of Seller to ensure figures are correct. Books are easy to cook and I don’t think that Buyer took the time to really look into the everyday operations of Seller. It is especially difficult in private equity-to-private equity circumstances. Monitoring internal communications and records of these communications in this day in age are ever more crucial. The fact that Seller shorted later financial periods to make Q end June artificially better, should be easily identified through the financial statements. Subsidiaries, book clubs, book returns, newsstands, retail outlets, and conferences should all be notable instances through Seller’s current and past financial statements. Buyer could have avoided loss by looking into the true components that are figured by numbers in financial statements. Given the increasing negotiating powers of sellers (like in this case); buyers should look to insurers to help reduce the risks of unknown liabilities. Representations and warranties insurance (RWI) reduce buyers exposure to unpredictable post-closing losses.