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September 7, 2021
In a recent decision, the Delaware Court of Chancery refused to dismiss fraud claims brought against a selling stockholder and its private equity affiliates. Although the purchase agreement was structured as a no-recourse transaction with none of the representations surviving closing, the court held that the seller and its affiliates could not insulate themselves from properly pled fraud claims based on false representations in the purchase agreement.
In Online HealthNow, Inc. v. CIP OCL Investments, LLC,1 the purchase agreement provided that none of the representations and warranties survived closing. It also included a non-recourse provision stating that only the contracting parties (and none of their affiliates) could have liability arising under the purchase agreement. After the closing, the buyer alleged that the seller and its non-signatory private equity affiliates committed fraud because they knew certain tax and accounts receivable representations in the purchase agreement were false.
The defendants argued that the fraud claims had to be dismissed because none of the representations survived closing, and the non-signatories were insulated from liability under the non-recourse provision. In rejecting this argument, the court wrote that “[u]nder Delaware law, a party cannot invoke provisions of a contract it knew to be an instrument of fraud as a means to avoid a claim grounded in that very same contractual fraud.”2 The court also rejected the defendants’ argument that a 78-day period between signing and closing had provided the buyer with a reasonable opportunity to discover the fraud.
Fraud Claims Under Private Company M&A Agreements
Fraud claims and “carve-outs” have received increasing attention in private company M&A transactions. The movement to shield sell-side parties from fraud claims has been driven significantly, but certainly not exclusively, by financial sponsors and their advisors. The sell-side focus on fraud has been driven by several concerns. First, there is a general desire to maximize protection for the seller’s affiliated funds and their principals and investors. Relatedly, financial sponsors want increased assurance that they do not have contingent liabilities when they distribute fund proceeds. Second, indemnification terms in sponsor-backed, middle-market M&A transactions have become increasingly seller friendly. A fraud claim can circumvent carefully negotiated baskets, caps, survival periods, and other terms in the purchase agreement. In some cases, the seller may have negotiated for a “clean exit” (also known as a “public company-style” deal). Similarly, when the buyer obtains representation and warranty insurance, the seller may have limited or even no post-closing indemnification obligations to the buyer, but the seller also tends to make more buyer-friendly representations and warranties in the purchase agreement. Thus, a buyer who is jilted or unable to recover under its insurance policy may try to bring a fraud claim. Third, there is the concern of who bears the risk of management/employee-level fraud of which the selling equity holders are unaware.
Evolving Deal Technology
Over the past ten years, “deal technology” has evolved considerably in addressing fraud claims. First, many purchase agreements disclaim extra-contractual representations and warranties,3 which, when done properly, prevent buyers from bringing any claims—whether based in contract or tort—other than those based on the representations and warranties in the contract.4 While extra-contractual disclaimers have been used for some time,5 they gained significant attention after the 2006 decision in Abry Partners V, L.P. v. F&W Acquisition LLC.6 Although some Delaware cases arguably have split hairs on whether purchase agreements contained the requisite combination of extra-contractual disclaimers from the seller and anti-reliance language from the buyer, it is generally accepted in Delaware that contracts can protect sellers from claims based on extra-contractual statements.
Second, many sellers have sought to define “fraud” as “intentional” fraud.7 These definitions make clear that buyers cannot pursue claims of equitable or constructive fraud, which might be based on a negligence or gross negligence standard. Some “fraud” definitions also purport to define “fraud” as a misrepresentation that certain individuals specified in the purchase agreement (e.g., the senior officers) knew was false.
Third, many purchase agreements include no-recourse provisions. These provisions purport to protect non-signatory affiliates and associates by providing that the only persons or entities that may have liability relating to the purchase agreement are the contracting parties.
Fourth, there has been focus on from whom the buyer can recover in the event of fraud. In some cases, the buyer can recover from all selling equity holders if the transaction was procured via fraud. In other cases, the purchase agreement may limit the buyer to recovering only from the persons who engaged in the fraud (although the buyer may have equitable claims to recover from selling equity holders who benefited from the fraud).
Fifth, a significant number of transactions in the middle market rely on representation and warranty insurance. Although this does not, in itself, limit a buyer’s ability to make a fraud claim, it often means that the buyer’s recourse against the sellers (as opposed to the insurer) is limited to fraud claims. Notably, in transactions with representation and warranty insurance, sellers often make representations and warranties that are more favorable to the buyer, which in theory might provide more bases for a buyer to bring a later fraud claim. In the event a buyer suffers a loss due to a breach of a representation or warranty of the sellers, and its claim against the representation and warranty insurance is denied, the buyer is left with little recourse other than to accept the loss or make a fraud claim directly against the sellers. In addition, an insurer’s normal waiver of subrogation rights against sellers does not apply to fraud claims.
Case Law Limitations
Importantly, state laws can differ on fraud claims and the effect of related purchase agreement terms. In Delaware under the Abry Partners V, L.P., decision, parties cannot insulate themselves from claims that the representations in the contract were the subject of intentional fraud. In that litigation, a key issue was whether a negotiated cap on the sellers’ aggregate liability under the purchase agreement also capped their liability for fraud. Then-Vice Chancellor Leo E. Strine, Jr., held that such a cap was against public policy and unenforceable, but he emphasized that this public policy was limited to claims of fraudulent misrepresentations in the contract.
Practitioners have thus grappled with the enduring legacy of Abry Partners and its application to evolving deal technology, weighing the freedom of contracts with public policy concerns. In a recent case, the Delaware Supreme Court rejected an attempt to hold a party liable for reckless statements when the contract expressly limited liability to “deliberate” fraud.8 This decision was consistent with Abry Partners,9 and it supports contractual definitions of “fraud” that try to limit such claims to intentional misstatements.
In the 2008 case of Sterling Network Exchange, the Delaware Superior Court indicated that parties could contractually shorten the statute of limitations for bringing a fraud claim if the buyer had a “reasonable” opportunity to discover and bring the claim.10 Prior Delaware cases have clearly held that contractual survival periods can shorten or extend the statute of limitation otherwise applicable to a contract claim. Online HealthNow, however, held that the buyer’s fraud claim was not barred by a non-survival provision. The court refused to follow Sterling Network Exchange and questioned its rationale.11
Delaware cases have also indicated that non-recourse provisions may not be effective against fraud claims if the non-parties knew of the false statement.12 While some practitioners have suggested sophisticated parties should be able to limit their ability to sue only named parties, those cases reflect both Abry Partners’ position on public policy and the reality that entities can only “speak” through human actors.13 In contrast, Delaware courts seem willing to uphold non-recourse provisions where the defendant did not have knowledge of the fraud.14
1 Online HealthNow, Inc. v. CIP OCL Investments, LLC, C.A. No. 2020-0654-JRS, mem. op. (Del. Aug. 12, 2021).
2 Id. at 4; see also id. at 52-53 (“[T]he Sellers cannot invoke a clause in a contract allegedly procured by fraud to eviscerate a claim that the contract itself is an instrument of fraud.”).
3 See SRS Acquiom, 2021 M&A Deal Terms Study at 45 (May 2021) (indicating that only 16 percent of agreements in the survey failed to include an extra-contractual disclaimer or non-reliance language).
4 See generally Steven M. Haas, Contracting Around Fraud Under Delaware Law, 10 Del. L. Rev. 49 (2008).
5 See id.
6 Abry Partners V, L.P. v. F&W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006).
7 For example, “fraud” has been defined as “an actual and intentional misrepresentation of a fact with the express intention that the other party rely on such misrepresentation.”
8 Express Scripts, Inc. v. Bracket Holdings Corp., 248 A.3d 824 (Del. 2021) (remanding a case where a jury was instructed to consider “recklessness” when the contract limited liability to “deliberate” fraud).
9 See Abry Partners, 891 A.2d at 1065 (stating that “the Buyer may not escape the contractual limitations on liability by attempting to show that the Seller acted in a reckless, grossly negligent, or negligent manner”).
10 Sterling Network Exchange, LLC v. Digital Phoenix Van Buren, LLC, 2008 WL 2582920 (Del. Super. Ct. Mar. 28, 2008).
11 Online HealthNow, at 47 (“[T]he basis for Sterling’s rationale is questionable, and a reflexive application of a “reasonableness” standard to survival clauses in the context of contractual fraud is likely not warranted.”).
12 Surf’s Up Legacy Partners, LLC v. Virgin Fest, LLC, 2021 WL 117036 (Del Super. Jan. 13, 2021) (“So, while the parties generally agreed the No Recourse Provision would bar ‘tort’ claims against the Managers, they also expressly agreed the APA would not bar the bringing of fraud claims. They could not have contracted otherwise. Delaware courts refuse to enforce contracts purporting to condone—or at least insulate—intentional fraud”) (emphasis added); Prairie Cap. III, L.P. v. Double E Hldg. Corp., 132 A.3d 35, 61 (Del. Ch. 2015) (“[I]t is reasonably conceivable that [the CEO and CFO] can be held liable for fraudulent contractual representations made by the Company because the Counterclaim sufficiently alleges that they knew that the representations were false. The Counterclaim also sufficiently alleges that they were the humans through which the Company made its representations.”); id. (“The Counterclaim sufficiently alleges that the [private equity firm’s board representatives] knew that the Company’s representations were false… [and that they] made statements to [the officers] intending for those statements to be repeated to [the buyer].”).
13 Prairie Capital, 132 A.3d at 59 (“Flesh and blood humans also can be held accountable for statements that they cause an artificial person, like a corporation, to make.”).
14 See Abry Partners, 891 A.2d at 1063 (“I find it difficult to fathom how it would be immoral for the Seller and Buyer to allocate the risk of intentional lies by the Company’s managers to the Buyer, and certainly that is so as to reckless, grossly negligent, negligent, or innocent misrepresentations of fact by the Company. Such an allocation of risk does not permit the Seller to engage in consciously improper conduct itself, it simply requires the Buyer to hold the Company and its speaking managers exclusively responsible for their own misstatements of fact.”); see also Online HealthNow, mem. op. at 36 n.150.