James Madison once famously said, “If men were angels, no government would be necessary.” One might similarly assert, with apologies in advance to our fourth president, that “if all parties to M&A transactions were angels, acquisition agreements would only be one page long.”
The reality, of course, is quite different. Acquisition agreements for both private and public M&A transactions regularly exceed 80 or more pages. Much of the content of these agreements is comprised of countless representations and warranties that sellers make to acquirers regarding the finances, operations, employees, assets and liabilities of the business being sold in the transaction. Many more pages are devoted to addressing what should happen if one or more of those representations turns out to be incorrect.
Most acquisition agreements (excluding those in which representation and warranty insurance is being obtained) will provide the buyer with an indemnification right against the selling parties if their representations and warranties turn out to have been incorrect at the time made. Parties to these agreements and their counsel will bargain vigorously over the scope and limitations of an indemnification package. Caps, baskets, survival periods, sandbagging (or anti-sandbagging) and other features are familiar concepts to M&A practitioners.
Equally familiar is an “exclusive remedies” provision, i.e., a clause stating that the indemnification provisions, with all of the applicable bargained for limitations, shall be the sole recourse for the buyer in the event that buyer seeks to assert a post-closing claim against the seller. Such a provision is designed to prevent the buyer from doing an “end run” around the limitations in the indemnification package that the parties just expended considerable energy negotiating, and making an uncapped, post-closing claim against the seller for damages.
One area in which parties have generally agreed that an “end run” around a negotiated indemnification package is appropriate arises from fraud. Simply put, if it turned out that the seller defrauded the buyer in the transaction, the buyer should not face any of the limitations in the terms of the acquisition agreement that might otherwise limit its recovery.
It was, therefore, once quite common to see a simple carve out—“except in the case of fraud” —inserted in one or more places in the indemnification package provisions of an acquisition agreement. Most sellers tended not to argue too passionately over this, as it would have been rather awkward for them to suggest that their exposure for indemnification claims for lying to the buyer ought to be capped or otherwise limited.
However, in recent years, M&A practitioners (particularly those representing sellers) have come to realize that the simple word “fraud” was not so simple after all and, depending on factors such as the governing law stated in the acquisition agreement, alleging fraud could give a buyer a much wider end run around the indemnification package limitations than was realized or intended.
For example, in comparing New York to Delaware law, New York law requires the fraudulently made representation or the fact to be material, while Delaware law does not have any such materiality requirement. The scienter requirement is different as well. While a representation made with the requisite indifference to the truth can form the basis of common law fraud in a
Delaware transaction, New York law requires knowledge of the untrue statement on the part of the party making the representation.
Furthermore, the plaintiff’s burden of proof in alleging fraud in New York is that all of the elements of common law fraud are established by clear and convincing evidence, which is a more difficult standard to satisfy than in Delaware, which requires only a preponderance of the evidence.
Hence, if an acquisition agreement contains a fraud carve out with no specified definition of “fraud,” a seller and its counsel likely will prefer that the agreement be governed by New York, rather than Delaware, law.
As an additional complication, common law fraud is not the only type of fraud recognized. Others include equitable fraud (arising from any misstatements of fact regardless of fault), promissory fraud (allowing a breach of contract claim to be converted into a fraud claim and, in some circumstances, potentially allowing the introduction of alleged extra-contractual promises of future performance that were not made part of the final negotiated agreement) and unfair dealings-based fraud (second guessing the overall fairness of the deal).
Given the potential (and sometimes unanticipated) breadth of the word “fraud,” counsel to sellers in M&A transactions have, in recent years, sought to insert into their acquisition agreements a definition for this term, such as: “Fraud shall mean common law fraud in New York.” Based on the burden of proof in New York (discussed above), seller’s counsel would happily stop there; however, savvy counsel (especially counsel for buyers) immediately point out that such a simple definition is not appropriate in today’s day and age.
Depending on various factors, including, of course, the relative bargaining power of the applicable parties, seller’s counsel should seek to include in a fraud definition: (i) a limitation to only intentional misstatements (specifically eliminating misstatements made recklessly); (ii) a limitation on the subject matter of potential misstatements to only those related to the representations and warranties set forth in the acquisition agreement itself (thereby excluding extra-contractual statements); (iii) a restriction on the persons to which misstatements constituting fraud could be attributed; and (iv) an exclusion of all types of fraud other than common law fraud (i.e., equitable fraud, promissory fraud and unfair dealings fraud).
Counsel to sellers would likely also want to include in the acquisition agreement a robust exclusive remedies provision and an acknowledgement by the buyer that it is not relying on any representations or warranties of the seller (or any seller affiliate or representative), other than those set forth in the acquisition agreement itself.
To foreclose a wide range of fraud claims, lawyers, particularly sell-side parties, should protect the bargained for agreement. New York law demands specifically drafted non-reliance provisions. Stated more bluntly, the parties cannot rely on a transaction agreement’s “miscellaneous” provisions’ integration clause. Even though public policy proscribes going unchecked, “a claim for fraud is barred by the existence of a specific disclaimer and failure to exercise reasonable diligence.” Steinhardt Group v. Citicorp, 272 A.D.2d 255 (2000).
A clearly drafted and properly placed non-reliance clause ensures that extra-contractual fraud claims are dead on arrival (and permit their dismissal at the pleading stage of a case without the necessity of discovery or a trial). Harbinger Capital Partners Master Fund I v. Wachovia Capital Markets, 910 N.Y.S.2d 762 (Sup. Ct. May 10, 2010), relying on Danann Realty Corp. v. Harris, 5 N.Y.2d 317, 320 (1959). Such a non-reliance provision will help the seller defeat a later attempt by the buyer to assert a fraud claim over extra-contractual matters, since reliance on a misstatement is an essential element of a common law fraud claim.
There is a limitation on how far a seller (even a seller with enormous bargaining power in a transaction) can go in limiting its exposure to post-closing fraud claims, at least under Delaware law. Such a strongly situated seller likely would include in the acquisition agreement an exclusive remedies provision that seeks to limit the available remedies for all misrepresentations to the specifically negotiated indemnification package, including any baskets and caps on damages.
Under the seminal ABRY Partners V v. F & W Acquisition, 891 A.2d 1032 (Del. Ch. 2006), the Delaware court stated that a fraud involving the “conscious participation in the communication of lies” by the “seller itself” and with respect to the representations and warranties specifically set forth in the acquisition agreement constituted the type of fraud, which, as a matter of public policy, could not be excluded by virtue of an exclusive remedy provision.
Beyond this fairly narrow exception, however, the Delaware courts will uphold the freedom of sophisticated parties to contract with one another in limiting their rights in this manner.
In sum, counsel for most buyers would probably prefer the “good old days” when a simple, undefined fraud carve out from the indemnity package was oftentimes accepted without negotiation; thereby, leaving the buyer the possibility of asserting a post-closing claim not subject to the caps, baskets and other limitations on indemnification set forth in the contract. In our constantly evolving world, negotiations among sophisticated parties consistently include a discussion over fraud definitions and related provisions.
Reprinted with permission from New York Law Journal, © ALM Media Properties LLC. All rights reserved.
