August 16, 2021

Contract Fraud: Negotiated Limitations on Liability Had “Too Much Dynamite”

I’ve always been a fan of “Butch Cassidy & the Sundance Kid,” and I give Vice Chancellor Slights 5 stars for the way he worked the film into his opinion in Online HealthNow  v. CIP OCL Investments. (Del. Ch. 8/21).  The case involved the enforceability of contractual limitations on post-closing claims that effectively eviscerate all claims, including those that allege the contract itself is an instrument of fraud. Vice Chancellor Slights began his opinion by invoking this famous scene, and concluded that the stock purchase agreement’s liability limitations simply contained “too much dynamite” to be enforceable:

Defendants’ motion to dismiss must be denied. Under 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. Stated more vividly, while contractual limitations on liability are effective when used in measured doses, the Court cannot sit idly by at the pleading stage while a party alleged to have lied in a contract uses that same contract to detonate the counter-party’s contractual fraud claim. That’s too much dynamite.

The Chancery Court’s 2006 decision in ABRY Partners v. F&W Acquisition, (Del. Ch. 2/06) played a central role in Vice Chancellor Slights’ opinion. In ABRY Partners, then Vice Chancellor Strine held that 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.” However, he went on to say that the contractual freedom to immunize a seller from liability for a false contractual statement of fact ends there. When a seller intentionally lies, a contractual provision limiting the remedy of the buyer to a capped damage claim would not be enforceable.

In arguing that contractual fraud claims against the target & its owner should be dismissed, the Online HealthNow defendants in pointed to the stock purchase agreement’s survival clause, which stated that the reps and warranties of the target and its private equity owner “shall not survive the Closing for any purpose.”  The defendants contended that, unlike the situation in ABRY Partners, this survival clause didn’t limit the buyer’s claim to a remedy, but simply limited the time during which it could pursue that remedy.

The defendants cited the Delaware Superior Court’s  decision in  Sterling Network Exchange v. Digital Phoenix Van Buren, (Del. Super. 3/08), which held that a survival clause limiting the time during which claims could be asserted did not run afoul of ABRY Partners. However, the Vice Chancellor rejected that argument, noting that the Court’s conclusion was contingent upon the existence of “a reasonable period of opportunity to unearth possible misrepresentations.”  He was somewhat skeptical of the decision in that case, but decided that in any event the reasonableness of the discovery period was not something that was suited for resolution on a motion to dismiss.

In arguing that fraud claims could not be asserted against the target’s owner, the defendants also pointed to the stock purchase agreement’s non-recourse provision. That said, among other things, that claims arising out of the SPA may only be asserted against “the Persons that are expressly identified as Parties and their respective successors and permitted assigns”; that “no officer, director, partner, manager, equityholder, employee or Affiliate of any Party . . . will have any liability or obligation with respect to [the SPA] or with respect to any claim or cause of action (whether in contract, tort or otherwise)” arising out of it.

The defendants cited language in ABRY Partners to the effect that “it [is] 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” in support of their position that the non-recourse clause was enforceable.  But Vice Chancellor Slights summarily dismissed that argument, noting that the quoted language arose during the Court’s discussion of a situation where the seller did not have actual knowledge of the fraud.  He concluded that the language cited by the defendants didn’t abridge ABRY Partners’ central holding – that public policy won’t permit a seller to avoid liability for contractual representations and warranties that it knew were false.

John Jenkins