From Kevin Miller of Alston & Bird: Here is a nice little contract case – Abry Partners v. F&W Acquisition – for fans of Vice Chancellor Strine’s opinions. It carefully lays out the interrelationship between representations, closing conditions and indemnification and demonstrates how careful drafting can advantage one party at the expense of the other while reminding us that in egregious cases courts of equity such as the Delaware Chancery Courts are prepared to entertain public policy arguments. We have posted law firm memos on this decision in the “Representations & Warranties” Practice Area.
1. Simplified Background
Sale of a publishing company by one private equity fund to another (both seller and buyer were sophisticated parties).
Entity being sold (the “Company”) makes most if not all of the representations regarding the business, operations and financial statements of the Company.
Seller makes limited representations (e.g., re: ownership of Company stock being sold) but provides closing officer’s certificate with respect to the accuracy of both Company and Seller representations and absence of MAE.
Buyer acknowledges in contract that the representations of the Seller and the Company contained in the contract are the only representations they have made and that they have no liability for the Buyer’s use or reliance on other information.
Contract also provides that Buyer’s exclusive remedies for inaccuracy, misrepresentation or breaches of representation is indemnification and that the maximum amount payable pursuant to the indemnification provisions is capped at a small fraction (i.e., 4%) of the purchase price.
After closing Buyer finds numerous alleged problems with the Company including problems arising from alleged misrepresentations relating to the financial statements and alleged fraud in connection with the preparation of financial information and the financial statements.
2. The Case
Buyer sued Seller and, among other things, sought rescission of the contract based in part on grounds of public policy – as to immunize sellers from rescission claims would “sanction unethical business practices of an abhorrent kind and … create an unwise incentive system for contracting parties that would undermine the overall reliability of promises made in contracts.” [page 3]
Seller sought dismissal of claims for rescission based on the exclusive remedy provision and other contractual limitations on liability in the contract.
3. The Holding
“Delaware law permits sophisticated commercial parties to craft contracts that insulate a seller from a rescission claim for a contractual false statement of fact that was not intentionally made….But the contractual freedom to immunize a seller from liability for a false contractual statement of fact ends there. The public policy against fraud is a strong and venerable one that is largely founded on the societal consensus that lying is wrong….For these reasons, when a seller intentionally misrepresents a fact embodied in a contract — that is, when a seller lies — public policy will not permit a contractual provision to limit the remedy of the buyer to a capped damage claim.” [page 3] (note: in contrast to the Restatement, Strine consciously draws the line at lies rather than recklessly conveyed false statements)
As a consequence, the court granted Seller’s motion to dismiss a rescission claim based on negligent misrepresentation but denied Seller’s motion to dismiss well pleaded claims alleging fraud.
4. Takeaways
Sellers can and should attempt to (i) limit their representations and have the entity being sold make all the business, operational and financial representations; (ii) include a provision acknowledging that the representations in the agreement are the only representations made by the Seller or the Company and that Seller and the Company have no liability for Buyer’s use or reliance on any other information (note: explicit anti-reliance language is essential under Delaware law); (iii) make the indemnification provisions (inclusive of any caps and other limitations on claims) the sole and exclusive remedy for inaccuracies, misrepresentations and breaches of representations. Buyers should be wary of all of the foregoing.
It is also worth noting that, at least in the private equity context where seller’s may not have significant involvement in the day-to-day affairs of the business being sold, it would not be sufficient for the Buyer to demonstrate that the Company’s managers intentionally misrepresented facts to the Buyer. In order to be entitled to rescission, the Buyer would have to show that the Seller (and not just the Company) knew that a representation was false and either communicated it directly or knew that the Company had. Without the knowledge of falsity by the Seller, Buyer would only be entitled to the limited remedies available to it pursuant to the contract’s indemnification provisions.
5. Miscellaneous
The decision is also interesting for its holding that the contractual choice of law provision (i.e., Delaware) applies to tort claims arising in connection with the agreement as well as contractual claims. Although all the parties were Delaware entities, the Buyer was based in Mass., the Seller was based in Rhode Island and the Company was based in Ohio. The Buyer had asserted that Mass. law should apply to the fraud claims. The court concluded that:
“Although each was physically located in a different New England state and although the Company was headquartered in Ohio, the Buyer and Seller were operating in interstate commerce and wanted a reliable body of law to govern their relationship. They therefore chose the law of the state each had looked to in choosing their juridical home and whose law they wished to have govern their entities. By this means, Buckeyes, Quahogs, and Minutemen could come together using the common language of the Blue Hen, which each embraced as setting forth a reliable and fair set of rules for their commercial relationship.” [page 25]
Chris Young, ISS’ M&A Research Director, blogs these thoughts in the new ISS “Corporate Governance Blog“:
“Conglomerates are not born rather they are created primarily via acquisitions. Many of the acquisitions used to build up conglomerates were undertaken based on the advice of investment bankers and attorneys, the same advisors that now counsel a reversal of course and the sale of “unrelated” businesses. Advisors first trumpet the supposed synergies to be derived from sharing the same roof, and then turn around and sing the praises of the “strategic focus” that comes from going it alone. Of course, the bankers and lawyers make their fees coming and going.
This change of heart phenomena is not limited to the build up and breakdown of conglomerates. On February 13, Merrill Lynch (MER) agreed to swap its mutual fund management business for a major stake in BlackRock Inc. (BLK). This move is in effect a reversal of the “one-stop shop” strategic rationale that was all the rage in the 1990s and which was used to justify a significant amount of M&A activity in the financial services industry.
Of course, hindsight is often 20:20, and no one can ever know for sure if the synergies forecasted for an acquisition will ever by realized. Yet the ease at which advisors apparently are able to “do a 180” should give shareholders pause when evaluating the importance of fairness opinions supporting acquisitions. Advisors may be able to profit twice despite being “wrong,” but shareholders do not have that luxury. As such, ISS recommends that shareholders apply a healthy dose of skepticism whenever a company justifies a deal based upon the receipt of a fairness opinion or highlights the participation of a brand name advisor.”
Tom Phillips of Effective Agreements shares this useful and amusing nugget from his life:
“One time, at DSC, we were negotiating with a European company, making a presentation on DSC’s financial performance. At one point the leader of our team and the leader of the European team bogged down in an increasingly heated discussion about inventory turns. The European leader insisted that our inventory turns were alarmingly high, indicating our products were not selling or we had invested far too much in inventory. Our team leader disagreed, saying our inventory turns were excellent both for our industry and for an American manufacturing company in general. The two men arrived at a complete impasse on the issue and were starting to get frustrated with each other.
As the junior member of the four man team by several levels, my job was to turn the slides. (That was not really my only job: I created the financial statements in Excel, etc.) As we were not going forward in the presentation, there was nothing I could do but sit and listen, and I happened to hear the European pooh-bah say the word “revenue” to one of his team.
I shouted “stop”, shocking the whole room into silence. I then asked the European leader how they calculate inventory turns? He answered, “dividing one year’s revenue by the inventory”. So, we explained that we calculate it using cost of sales: for the numbers to be comparable, he had to effectively double ours.
The “take-away” on this one (besides European accounting is not always the same as GAAP): every negotiating team should have one person whose assignment is to listen, and nothing else!”
In this podcast, Lisa Kunkle, a Partner of Jones Day, provides some gloss on the portions of the SEC’s recent executive compensation proposals that could implicate M&A, including:
– How do the SEC’s proposals deal with COC and termination payments?
– What are possible areas where commentators will focus?
– What are good examples already out there where companies have fully disclosed potential COC or termination payments to executive officers?
– What other modifications might need to be made to change in control agreements and deferred compensation plans as a result of 409A?
On Friday, the UK Panel on Takeovers and Mergers (which administers the City Code on Takeovers and Mergers) issued a consultation paper. This consultation paper mainly is a clean-up proposal as it looks to tweak 30 rules that come into affect later this year.
For background, consultation papers are the equivalent of proposing releases issued by the SEC – the UK Panel is required to publish proposed rules or amendments and consider responses from the public before publishing a statement of its conclusions.
The UK Panel is currently a non-statutory body, but this status is expected to change once the European Takeovers Directive has been implemented this summer.
Below is a nice explanation of why so many hostile deals are taking place in Europe, courtesy of this article from BreakingViews:
What is it about 2006 that makes executives so hostile? A handful of big, bold unsolicited cross-border takeovers have been launched in the first few weeks of the year. This comes after a year in which hostile bids actually fell. There were just 85 deals announced in 2005 worth $192bn (E158bn), down from 109 worth $251bn. The value of hostile offers in January is already twice what it was this time last year.
But it’s the audacity of some recent bids that surprises most. Take Mittal Steel’s E19bn bid for Arcelor. Not only is the Netherlands-based steelmaker funding the deal largely with debt, it’s taking a stab at a company many in France consider a homegrown champion.
Linde’s bid for Britian’s BOC, worth nearly £8bn (E12bn) , is another humdinger. Even before news of the offer hiked BOC’s shares, Linde was nearly a third smaller in size. That’s audacious. So, too, was the unsolicited attempt by chemicals group BASF to acquire Engelhard of the US. Given Engelhard’s staggered board and the ease of use of poison pills in the US, BASF’s endeavour borders on foolhardy.
What’s driving this? For one, credit conditions remain historically easy. Companies may be taking advantage of this before the cycle inevitably turns. And executives are feeling confident as their share prices have blossomed. Linde is up almost 50% in the past year; BASF a third. Moreover, investors are egging them on. Mittal shares surged on its ballsy bid Friday. Linde’s have also rallied since its BOC bid was made public. BASF stock has held up despite daunting challenges to its Englehard bid.
None of this means a boom in hostiles will necessarily arrive, however. To succeed, companies must have an edge before going hostile. Mittal, for example, has timing on its side. Arcelor became vulnerable to a deal by overpaying for Dofasco and going hostile itself for the Canadian steel group. Linde, in the meantime, may be playing on the fact that BOC is the only one in the industrial gases industry that regulators may allow.
As for BASF, its edge is less clear as it kicked Engelhard into a competitive auction. Its only advantage may be in its possible willingness to overpay. Once that becomes apparent, managers considering hostile takeovers of their own may adopt restraint – or face the wrath of suddenly less supportive shareholders.