DealLawyers.com Blog

In Paragon Metals Holdings v. Smith, (Del.; 7/26), the Delaware Supreme Court reversed a Superior Court decision precluding buyers from relying on seller’s reps & warranties in a common law fraud claim due to due diligence gaps that the lower court concluded amounted to their “willful blindness” to the inaccuracy of those reps.

The case arose out of a 2018 acquisition of Paragon Metals from its founder and CEO by an investor group. In the purchase agreement, the founder represented that he was unaware of any material changes in business terms with the company’s major customers. Despite that representation, two of Paragon’s largest customers had in fact indicated plans to significantly reduce their business with the company. The buyers failed to discover the customers’ plans during due diligence, despite several warning signs.  After the closing, the buyers learned of the impending loss of business and ultimately sued the founder for common law fraud based on his alleged misrepresentations.

The Superior Court agreed that the founder had made false representations to the buyers, but it held that the buyers were unable to justifiably rely on those allegedly fraudulent representations because their failure to conduct reasonable due diligence constituted “willful blindness” with respect to the falsity of those warranties.

In rejecting the Superior Court’s conclusion, the Supreme Court observed that willful blindness requires a party to “take deliberate actions to avoid confirming a high probability of wrongdoing and who can almost be said to have actually known the critical facts.” The Court said that the lower court went to far in applying that stringent standard in these circumstances:

Determining what constitutes “reasonable” reliance can be difficult, as the line lies somewhere between actual knowledge and negligence. On one hand, “it is axiomatic that a plaintiff does not justifiably rely on a defendant’s misrepresentation if the plaintiff knows that the representation is false.” On the other, a plaintiff’s “failure to discover the fraud through due diligence does not excuse it.”

Although Delaware reveres freedom of contract, “contracts may not insulate a party from damages or rescission resulting from the party’s fraudulent conduct.” Nothing on the face of §§ 3.23 or 3.8 gave [the buyers] reason to doubt the truth of the warranties. Instead, when [the buyers] raised questions, Smith concealed the truth. When [the buyers] questioned Smith about the strike-through language that said ZF was “going to decrease their purchases,” Smith was untruthful. He told [the buyers] that ZF and FCA were going to shift their purchase orders from one bracket type to another and would not decrease the total quantity of brackets they purchased.

Smith stresses that he placed [the buyers] on notice of Paragon’s declining orders by sending it an email that referred to the ZF Letter and that [the buyers] should have read the email. Yet, in the same email, Smith wrote that he would review the listed items with [the buyers] in ten days. It therefore should not have altered the court’s analysis that [the buyers] did not prioritize reading and digesting the email when Smith stated in the same email that he would discuss it with [them] at a later date.

Ultimately, the Supreme Court concluded that the record didn’t establish that the buyers took deliberate actions to avoid learning of the changes in Paragon’s business terms with its customers, and that while their trust in the founder may have been naïve, it did not amount to deliberate action to avoid discovering the truth.

– John Jenkins