Failure to Disclose a Lawsuit When Selling a Business

When does a Minnesota seller have to disclose a pending lawsuit?

A Minnesota seller has no general duty to disclose a pending lawsuit, but special circumstances may create one, and the purchase agreement can require disclosure by contract. The examples the Minnesota Supreme Court gives are a statement the lawsuit makes misleading, special knowledge of facts the buyer cannot reach, and a confidential or fiduciary relation to the buyer.

The Minnesota Supreme Court set out the rule in Klein v. First Edina National Bank, 196 N.W.2d 619 (Minn. 1972): “As a general rule, one party to a transaction has no duty to disclose material facts to the other. However, special circumstances may dictate otherwise.” The court then gave three examples:

1. “One who speaks must say enough to prevent his words from misleading the other party.”
2. “One who has special knowledge of material facts to which the other party does not have access may have a duty to disclose these facts to the other party.”
3. “One who stands in a confidential or fiduciary relation to the other party to a transaction must disclose material facts.”

In a business sale, the first circumstance comes up at once, because buyers ask about litigation and sellers answer. An answer that mentions one case and leaves out another is a partial answer, and the say-enough rule reaches it. The purchase agreement then adds a separate contract duty: a written representation that no litigation is pending or threatened is a promise the buyer can enforce on its own terms. My page on the duty to disclose in contracts covers the common-law rule in more depth.

Residential home sales follow a different rule. Minn. Stat. § 513.55, subd. 1 requires that “Before signing an agreement to sell or transfer residential real property, the seller shall make a written disclosure to the prospective buyer,” and § 513.52, subd. 4 limits that statute to residential real property, which “means property occupied as, or intended to be occupied as, a single-family residence,” so it does not govern the sale of a business.

Can you sell a business with a pending lawsuit, and how does it affect valuation?

A seller can sell a business with a pending lawsuit. The lawsuit becomes one more cost the buyer prices into its offer, and disclosing it up front lets the seller negotiate how that cost is paid rather than defend a fraud claim after closing.

A buyer values a pending case by estimating what it will cost the business: a likely judgment or settlement, the legal fees to get there, and the management time and customer disruption along the way. The buyer then handles that estimate in one of three ways:

• A price discount. The buyer lowers its offer by its estimate of the case’s cost, usually weighted toward the worse outcomes, because the buyer cannot judge the case as well as the seller can. A discount is final, so it suits a case whose cost is fairly certain, such as one with a settlement already in negotiation.
• Contingent pricing. Part of the price depends on how the case ends, through a deferred payment or an earnout released only if the case resolves within a stated amount.
• An escrow or holdback instead of a price cut. The buyer pays the full price, but a portion sits in escrow until the case ends. If the case resolves for less than the escrow, the seller receives the remainder. This structure suits a case whose outcome is uncertain.

A seller who believes the case is weak is usually better served by an escrow or contingent payment than by a permanent discount, because the seller recovers the money the buyer reserved once its view of the case proves right. A buyer who learns of the case late in the deal tends to discount more, because the surprise makes it question what else it has not been told.

How should sellers assess the risks of pending litigation before a sale?

I suggest that a seller size its own case before a buyer does, because the buyer will discount for every question the seller cannot answer. The seller’s litigation counsel can give a written view of these points:

1. Stage. A case at the pleading stage carries more uncertainty than one past discovery or set for trial, and buyers price uncertainty.
2. Likely outcome. A realistic range of results, from dismissal through an adverse judgment, with counsel’s view of which is most likely.
3. Exposure. The amount demanded, the realistic damages, and the defense costs to reach a result.
4. Insurance. Whether the seller’s liability carrier has accepted the defense, under a reservation of rights or not, and what deductible and policy limits apply. Covered exposure reduces what a buyer needs to reserve.
5. Settlement before sale. Whether settling now, even for more than the seller thinks the case is worth, would cost less than the discount or escrow a buyer will demand while the case stays open.

A settled case is a fixed number a buyer can verify, while an open case is a range the buyer will price at its high end. I suggest that a seller weigh that difference before taking the business to market.

What claims can a buyer bring when the seller hid a lawsuit?

A buyer can bring a fraud claim, a claim for breach of the purchase agreement’s litigation representation, and, when the deal was a sale of a security, a claim under the Minnesota Securities Act. Each claim has different elements, and the buyer can plead them together.

Fraud requires five elements, restated by the Minnesota Supreme Court in Hoyt Properties, Inc. v. Production Resource Group, L.L.C., 736 N.W.2d 313 (Minn. 2007). The first is “a false representation by a party of a past or existing material fact susceptible of knowledge.” The others are knowledge of the falsity (or speaking without knowing whether it was true), intent to induce reliance, reliance that caused the buyer to act, and resulting financial loss. Hoyt is close to this topic on its facts: after signing a settlement that released a parent company, the plaintiff learned of a third party’s lawsuit alleging facts that contradicted what the other side had told it, and it sued to rescind. The court held the statements were actionable, affirmed the court of appeals, and remanded the case to the district court for further proceedings.

A contract claim is simpler in one respect: the buyer proves the representation, its falsity, and the loss, under the terms the parties wrote. The agreement’s survival period, indemnity cap, and notice terms then shape what the buyer recovers, which is why the drafting points later on this page matter as much as the fraud rules.

How does the Minnesota Securities Act apply to a stock sale?

When the buyer purchases stock or another security, Minn. Stat. § 80A.68 makes it unlawful “to make an untrue statement of a material fact or to omit to state a material fact necessary in order to make a statement made, in the light of the circumstances under which it is made, not misleading.” A hidden lawsuit behind a “no litigation” statement can fit that wording.

The civil remedy is in Minn. Stat. § 80A.76(b). The seller is liable to a purchaser who did not know of an omission of a material fact needed to keep a statement made from misleading, unless the seller carries a burden of proof. The statute states that burden this way: “the seller not sustaining the burden of proof that the seller did not know and, in the exercise of reasonable care, could not have known of the untruth or omission.” That shifts a burden the common law leaves on the buyer: the seller must prove it did not know and could not have known with reasonable care. “The purchaser may maintain an action to recover the consideration paid for the security, less the amount of any income received on the security, and interest from the date of the purchase, costs, and reasonable attorneys’ fees determined by the court, upon the tender of the security, or for actual damages as provided in paragraph (3).”

Whether the deal is a sale of a security depends on Minn. Stat. § 80A.41. A security “means a note; stock; treasury stock” and other listed instruments, and the definition includes as an investment contract, “among other contracts, an interest in a limited partnership and a limited liability company.” Minnesota then carves out the negotiated sale of a whole closely held business. The definition “does not include any equity interest of a closely held corporation or other entity with not more than 35 holders of the equity interest of such entity offered or sold pursuant to a transaction in which 100 percent of the equity interest of such entity is sold as a means to effect the sale of the business of the entity if the transaction has been negotiated on behalf of all purchasers and if all purchasers have access to inside information regarding the entity before consummating the transaction.” If any one of those conditions is missing, such as a sale of less than 100 percent of the equity, an entity with more than 35 holders, a deal not negotiated on behalf of all purchasers, or a purchaser without access to inside information, the exclusion does not apply.

Federal law has its own rule. SEC Rule 10b-5 makes it unlawful “To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading,” and the rule applies “in connection with the purchase or sale of any security.” The Minnesota exclusion does not answer the federal question.

Who is personally liable for a hidden lawsuit in a stock sale?

In a sale of a security, the Minnesota Securities Act can make individuals liable along with the seller. Subsection (b) makes liable the person that “sells a security” by means of “an omission to state a material fact necessary in order to make the statement made, in light of the circumstances under which it is made, not misleading,” and paragraph (g)(2) reaches an executive officer or director of that person, so in a sale it reaches the officers and directors of the seller. Minn. Stat. § 80A.76(g) makes the following persons “liable jointly and severally with and to the same extent as persons liable under subsections (b) through (f)”: “an individual who is a managing partner, executive officer, or director of a person liable under subsections (b) through (f), including an individual having a similar status or performing similar functions, unless the individual sustains the burden of proof that the individual did not know and, in the exercise of reasonable care could have known [sic], of the existence of conduct by reason of which the liability is alleged to exist.”

Two other parts of the same section matter in negotiation. Under paragraph (l), “A condition, stipulation, or provision binding a person purchasing or selling a security or receiving investment advice to waive compliance with this chapter or a rule adopted or order issued under this chapter is void.” A clause in the stock purchase agreement waiving the act does not protect the seller. Under paragraph (m), “The rights and remedies provided by this chapter are in addition to any other rights or remedies that may exist,” so the buyer can pursue the statutory claim alongside fraud and contract claims.

How does due diligence affect a buyer’s fraud claim?

A buyer has no duty to investigate before relying on a seller’s statement, but an investigation the buyer does conduct can be used against it. Both rules come from the Minnesota Supreme Court, and the difference turns on what the buyer examined.

In Hoyt, the court held that a fraud plaintiff must show “both actual and reasonable reliance,” and added that “The listener is not under an obligation to conduct an investigation and thus may rely on the representation so long as it is not known by the listener to be false and is not obviously false.” The legal training and business experience of Steve Hoyt, the attorney who owns the plaintiff company, did not make the company’s reliance unreasonable as a matter of law; that was a question for trial.

In Valspar Refinish, Inc. v. Gaylord’s, Inc., 764 N.W.2d 359 (Minn. 2009), the result went the other way. The court said “Reliance in fraud cases is generally evaluated” in light of “the aggrieved party’s intelligence, experience, and opportunity to investigate the facts at issue,” and that “When a party conducts an independent factual investigation before it enters into a commercial transaction, that party cannot later claim that it reasonably relied on the alleged misrepresentation.” The parties there were “sophisticated business equals operating in a commercial setting,” and the buyer had tested the very paint products the statements concerned. The court rested the result on a second ground as well: the statements were predictions of future results, not statements of existing fact.

A litigation search is a narrower inquiry than Valspar’s product testing, because court records do not show a demand letter, an unfiled claim, or a case in another state the buyer did not search. I suggest that buyers keep their own search results and the seller’s written answers side by side, because the gap between the two is the evidence of what the buyer could and could not find. My page on reliance in fraud claims covers the standard, and my page on the anti-sandbagging clause covers the contract term that ties a buyer’s recovery to what it knew before closing.

What can a buyer do when the seller is not responding to due diligence?

A seller who ignores or stalls the buyer’s litigation questions is telling the buyer something, and the buyer has more leverage before closing than after it. Silence is a weaker basis for a fraud claim than a misleading answer. Under Klein, “As a general rule, one party to a transaction has no duty to disclose material facts to the other,” so a seller who has made no statement owes disclosure only in special circumstances, such as special knowledge of facts the buyer cannot reach. The buyer’s firmest protection against a silent seller therefore comes from the contract and from its willingness to delay or walk away.

I suggest these steps when a buyer’s diligence requests go unanswered:

1. Put the requests in writing with a response date, so the record shows what the buyer asked and what the seller declined to answer.
2. Insist on a written litigation representation and disclosure schedule covering pending and threatened claims, whatever the seller does or does not say in diligence. A representation is enforceable as a contract term even where silence would not support fraud.
3. Make complete answers a closing condition, so the buyer is not obligated to close until the seller answers its litigation questions and delivers the schedule.
4. Delay the closing or walk away if the seller still will not answer. An unanswered litigation question is a reason to price the deal as if the answer were bad, or not to do the deal.

If the seller answers some questions but not others, the answers it does give fall under the Klein rule that “One who speaks must say enough to prevent his words from misleading the other party.”

What should buyer due diligence cover for a litigation-heavy business?

A buyer’s diligence on a business with open cases has three parts: finding every claim, putting a cost on each one, and checking for regulatory problems that could become the next claim.

Identifying Litigation Risks

I suggest that the buyer search the courts in every state where the business operates and ask the seller for its open and closed case list for the past several years, demand letters, agency correspondence, insurance claim history, and loss runs from its carriers. Grouping the results by type (contract, employment, injury, intellectual property, regulatory) shows patterns, such as repeated claims from the same practice or product, that point to claims not yet filed.

Assessing Financial Impacts

For each case, estimate the cost by working through four numbers: the realistic range of judgment or settlement, the probability of each result, the defense costs to reach it, and the share an insurer will pay after the deductible and within policy limits. The uninsured, probability-weighted total is the buyer’s expected cost; the high end of the range is its worst case.

Those numbers then become terms. The expected cost supports a price reduction or an escrow, and the gap between the expected cost and the worst case supports a holdback or a special indemnity for that case. Sizing an escrow at the worst case, with release of the excess when the case ends, protects the buyer without making the seller give up money it may never owe.

Verifying Legal Compliance

The buyer should review the target’s licenses and permits, whether each one transfers to the buyer or must be reissued, any past or open agency investigations or penalties, and its compliance with the rules of its industry and with employment law. An open agency inquiry or a known compliance failure is a lawsuit that has not been filed yet, so I suggest that the purchase agreement’s definition of litigation expressly include agency investigations, inquiries, and notices of violation, and that the disclosure schedule list each one.

When do merger and no-reliance clauses fail to bar a fraud claim?

A merger clause or no-reliance clause does not end a fraud claim as a matter of law under Minnesota law unless the written agreement expressly contradicts the misrepresentation. The Court of Appeals applied that rule to a fraudulent-omission claim in Great Plains Educational Foundation, Inc. v. Student Loan Finance Corp., 954 N.W.2d 844 (Minn. App. 2020).

The court’s first syllabus point reads: “The presence of both a no-reliance and an integration clause in a settlement agreement does not as a matter of law bar a subsequent claim for fraudulent inducement of that settlement agreement based on alleged oral misrepresentations unless there are express terms in the settlement agreement that contradict the alleged oral misrepresentations.” Its reasoning rests on an older line of Supreme Court decisions: “The Minnesota Supreme Court has long held that fraud cannot be waived by a contractual disclaimer.”

Great Plains involved a settlement agreement, and the plaintiff there alleged that the other side misrepresented or left out its assets and liabilities during negotiations. The case came up on a motion to dismiss, so the court accepted the complaint’s facts as true and sent the case back for further proceedings. For a seller, the practical lesson is that a merger clause is no substitute for disclosure. For a buyer, the clause does not by itself defeat a claim that the seller hid a lawsuit.

What remedies can a buyer choose after discovering the lawsuit?

A buyer who was defrauded into the purchase can either undo the deal or keep it and sue for damages, but not both. In Great Plains, the Court of Appeals restated that a party “who has been induced to enter a contract by fraudulent misrepresentations may elect to rescind the contract or sue for damages,” and that a party choosing rescission must undo the whole deal: “rescission of the contract must be in toto.”

The remedies work this way:

• Rescission unwinds the sale. It returns the business to the seller and the price to the buyer. My page on undoing a signed contract after fraud covers the steps.
• Damages let the buyer keep the business. For the measure, Hoang Minh Ly v. Nystrom, 615 N.W.2d 302 (Minn. 2000) involved a restaurant sale the parties later cancelled, and the trial court there applied the common-law fraud formula: “the difference between what appellant paid for the restaurant and the fair market value of the restaurant, plus damages resulting from reasonable attempts to mitigate.”
• Securities remedy. In a sale of a security, § 80A.76(b) lets the buyer recover the price paid, less any income received on the security, plus interest, costs, and reasonable attorneys’ fees, upon tender of the security. “A purchaser that no longer owns the security may recover actual damages as provided in paragraph (3).”

Attorney fees are the gap. Ly held that a one-on-one purchase of a business to operate it falls within the Consumer Fraud Act, Minn. Stat. § 325F.69, subd. 1. That section reaches fraud and misrepresentation made “with the intent that others rely thereon in connection with the sale of any merchandise.” The private remedy in Minn. Stat. § 8.31, subd. 3a lets “any person injured by a violation of any of the laws referred to in subdivision 1” recover damages and “reasonable attorney’s fees,” but Ly held that the statute as a whole “applies only to those claimants who demonstrate that their cause of action benefits the public.” The buyer there “was defrauded in a single one-on-one transaction,” so the court denied fees. Two justices disagreed on that point.

Timing also matters. A fraud claim “shall not be deemed to have accrued until the discovery by the aggrieved party of the facts constituting the fraud,” under Minn. Stat. § 541.05, subd. 1. The facts constituting the fraud are deemed discovered when they were “actually discovered” or when they, “by reasonable diligence, should have been discovered,” as the Minnesota Supreme Court stated in Doe v. Archdiocese of Saint Paul & Minneapolis, 817 N.W.2d 150 (Minn. 2012). Securities claims carry their own limits in § 80A.76(j), which begins “A person may not obtain relief” and then sets periods that run from the violation and from discovery. I suggest that a buyer who finds a hidden lawsuit check the current text of both sections, and any shorter claim period in the purchase agreement, before choosing a remedy, because the periods differ by claim. Rescission has a separate limit: in Hemming v. Ald, Inc., 155 N.W.2d 384 (Minn. 1967), a fraudulent sale of laundromat equipment, the Minnesota Supreme Court said the right to rescind “may be lost where the buyer either affirms the transaction with knowledge of the fraud” or “where the buyer fails to disaffirm the transaction within a reasonable time after discovery of the fraud.”

What happens to the pending lawsuit itself after the sale closes?

Who carries the lawsuit after closing depends on the deal’s structure. In a stock sale, the company that was sued keeps being the defendant, and the buyer now owns that company. When a Minnesota corporation sells all or substantially all of its property and assets, the buyer takes on the seller’s liabilities only as the contract or a statute provides.

Minn. Stat. § 302A.661, subd. 4 states the rule for a disposition of all or substantially all of a corporation’s property and assets under that section: “The transferee is liable for the debts, obligations, and liabilities of the transferor only to the extent provided in the contract or agreement between the transferee and the transferor or to the extent provided by this chapter or other statutes of this state.” It adds that “The transferee shall not be liable solely because it is deemed to be a continuation of the transferor.” That subdivision governs corporations under chapter 302A; an LLC seller’s asset sale is outside it.

The structure changes who is hurt by a hidden lawsuit. A stock buyer inherits the defense costs and any judgment through its ownership, so nondisclosure hits it directly. Under subdivision 4, a buyer of all or substantially all of a corporation’s assets leaves the lawsuit with the seller unless the contract or a statute provides otherwise. The hidden case can still matter, though, if the agreement assumes all liabilities of the business or if the seller drains the sale proceeds and cannot pay a judgment.

How are purchase price adjustments and litigation costs managed during the sale?

Once a pending case is disclosed, the parties choose how its cost is paid (the pricing options in the valuation section above) and who runs the case. Two terms decide who runs it:

• Defense costs between signing and closing should be assigned in the agreement. The seller usually keeps paying and controlling the defense until closing, and the buyer should require that the seller not settle, admit liability, or change litigation counsel without the buyer’s consent.
• Control after closing follows the indemnity. A seller that indemnifies the buyer for the case will want to control the defense and settlement, subject to the buyer’s consent to any settlement that binds the business going forward.

A pending case also affects the buyer’s financing. A lender reviewing the deal will see the case in its own diligence and may ask for a reserve, an escrow, or proof of insurance coverage before it funds, which can slow the closing or reduce what the buyer can borrow. Disclosing the case early, with the seller’s counsel’s assessment and the insurance position, gives the buyer’s lender what it needs and keeps the financing timeline intact.

How should the purchase agreement handle a known lawsuit?

A purchase agreement should handle a known lawsuit by naming it, pricing it, and assigning it. Each step turns a fact that could support a fraud claim into a written term both sides agreed to.

I suggest these terms:

1. A disclosure schedule listing each pending and threatened claim by caption, court, amount demanded, and status, so the seller’s representation is complete on its face.
2. A defined term for litigation that says whether demand letters, agency inquiries, and unfiled claims count.
3. A special indemnity for a known liability that covers the scheduled case outside the general indemnity cap and basket.
4. An escrow or holdback sized to the claim, so the buyer is not left collecting from a seller who has spent the proceeds.
5. A bring-down clause that repeats the litigation representation at closing and requires an officer’s certificate.

For the seller, a disclosed claim becomes a negotiated price term, while a hidden one can support rescission and, in a securities sale, personal liability for the seller’s officers and directors.

Why does a seller with a pending lawsuit need transaction counsel?

The seller’s litigation counsel defends the case; transaction counsel decides how the case appears in the deal documents, and the risks on this page live in those documents. An attorney who handles the sale can help with these tasks:

• Drafting the disclosure schedule and the definition of litigation so the schedule matches the representation word for word and a demand letter or agency inquiry is not left out.
• Avoiding a waiver that does not work, since in a sale of a security § 80A.76(l) voids a waiver of the act (see above), so the seller’s protection has to come from complete disclosure.
• Protecting officers and directors from the § 80A.76(g) liability described above.
• Pricing and structuring the case through the escrow, special indemnity, and defense-control terms described above, coordinated with litigation counsel’s assessment.

Next Steps for Buyers and Sellers

A seller who discloses every pending and threatened claim in writing leaves no hidden claim to support a fraud theory. The disclosure is itself a statement, though, and under Klein one who speaks must say enough to prevent his words from misleading the other party. For a buyer who finds a hidden lawsuit after closing, I suggest identifying which claims fit the deal (fraud, the contract’s representation, and the securities act if stock changed hands) before choosing between rescission and damages. That order matters because a buyer who rescinds must undo the whole deal, and under Hemming the right to rescind may be lost where the buyer fails to disaffirm the transaction within a reasonable time after discovery of the fraud. More on these agreements is in my Minnesota contracts practice materials. If you would like me to analyze a purchase agreement’s litigation representation and disclosure schedule, or a lawsuit you learned of after closing, email [email protected] with a brief description.