February 24, 2006

Allocating Risk in M&A Contracts

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]