Imagine that two months subsequent to the closing of an investment in a manufacturing company, the incoming CFO has combed through the target’s books only to find that the financials—the very financials that determined the purchase price—have been severely misstated.
The determination is that there has been a breach of contract and even the “materiality” qualifiers sprinkled throughout the contract will not come into play in this situation. The seller has made material misstatements and has committed fraud. Or, what if the seller’s conduct doesn’t quite rise to the level of actionable fraud? Where should the buyer go? What are the remedies? Consequential damages? Rescission? What protections do the four corners of the definitive purchase agreement that was painstakingly negotiated provide the buyers and its limited partners?
Not long ago, in Abry Partners V, L.P. vs. F&W Acquisition LLC, the Delaware Court of Chancery provided a few answers to these questions. The court, reviewing a motion to dismiss brought by
In the case in question, Abry Partners negotiated with Providence for the purchase of one of its portfolio companies, F&W Publications, which is in the business of publishing and selling books. After taking over ownership, Abry recognized that F&W’s financial statements had been severely manipulated and that F&W had misrepresented the status of the implementation of a book order fulfillment system integral to the business. Abry alleged that the failure of this system caused F&W to lose several of its customers, most notably Amazon.com. Abry believed that the true value of F&W was probably somewhere around $400 million, $100 million less than it paid.
Believing that it had been defrauded, Abry sought to rescind the transaction and recover damages. However, the stock purchase agreement (SPA) contained very few protections. In addition to a “no reliance” clause, the SPA included an “Indemnity Fund” that limited Providence’s liability exposure to a fund set at $20 million, an amount that totaled only 4% of the $500 million dollar purchase price. The SPA made the Indemnity Fund the exclusive remedy for Abry in the event of a misrepresentation by Providence and barred rescission claims.
Faced with the fact that it had been defrauded, Abry filed suit against Providence alleging that Providence fraudulently and negligently induced it to enter into the SPA. Abry sought to rescind the transaction or, in the alternative, to recover damages exceeding those allowed under the SPA. As many expected, Providence argued that Abry’s claims should be dismissed because the parties specifically negotiated and agreed to the applicable remedy and that the damages granted to Abry should not exceed the $20 million dollar cap. Essentially, Providence argued that, given the sophistication of the parties, the court should enforce the four corners of the agreement.
Ultimately, the court denied Providence’s motion to dismiss, stating that Abry could rescind the transaction and recover damages in addition to those outlined in the SPA if it could prove fraud, as “fraud vitiates every contract.” Abry’s winning argument was essentially and simply that to enforce the provisions limiting Providence’s liability in a situation in which Providence intentionally misrepresented material facts is against public policy.
In response to Abry’s argument, the court acknowledged that it was not in the business of condoning unethical business practices. The court pulled back its ruling to some extent, however, noting that Delaware law allows sophisticated parties to negotiate provisions that protect themselves and that Delaware strongly acknowledges the American tradition of freedom of contract. As such, Delaware law still permits parties to include provisions that insulate a seller from rescission if the false statement of fact was not made intentionally.
In the case, most believe the Delaware Court of Chancery got it right. The moral of the story is as it should be: 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. Rather, the buyer is free to pursue a claim for rescission or for full compensatory damages. Absent fraud, Delaware courts will enforce the four corners of the definitive purchase agreement and a buyer will be limited by the protections it negotiated.
Despite the fact that Abry was victorious in overcoming Providence’s motion to dismiss and was able to settle the case, there’s still a downside. Because Abry failed to negotiate protections into the SPA, and because Abry is considered to be a “sophisticated party,” Abry found itself at the mercy of the courts, had the high burden of proving fraud, and was forced to pay the legal fees attendant with bringing such an action.
Many lessons can be gleaned from the Abry decision. First, buyers must take care in negotiating their definitive purchase agreements, as they should not expect that Delaware courts will provide them with remedies in addition to those contained in the four corners of the agreement. Additionally, even though a buyer may be able to recover damages in addition to those provided in the definitive purchase agreement, if the buyer is a “sophisticated party,” the court might hold it to a higher standard of proof.
The Abry decision also suggests that buyers should engage in a strict diligence review before a deal closes to make sure that it knows all of the company’s secrets. Though, in the case of Abry, we cannot comment on whether any advisor, accountant or otherwise, would ultimately be held liable for the failure to properly disclose the client’s financials, that would, perhaps, be the next avenue of recovery.
When on the buy-side, investors should arm themselves with the following provisions in their definitive purchase agreement:
• Explicitly set forth damages for fraudulent, intentional, willful or wanton misconduct, recklessness and gross negligence. The provision that protects you the most will be dollar one, no cap and no deductible. Though it may be reasonable in certain circumstances to provide that the seller’s liability is capped at a certain dollar amount and that the buyer will only bring a claim if its damages fill up an agreed upon basket, these qualifiers should not apply to instances in which the buyer is able to prove that the seller intentionally misrepresented facts relied upon by the buyer in entering into the agreement. Practically speaking, however, most sellers will vehemently resist including a remedy for the buyer in the event the buyer uncovers their gross negligence.
• Provide that the limitation on remedies does not apply to actions that rise to the level of fraud or intentional misconduct. Essentially, the agreement should explicitly state that remedies for damages resulting from fraud or intentional misconduct are neither limited to actual monetary damages nor to remedies provided under the purchase agreement. If the agreement includes a provision stating that the buyer’s remedies are limited only to those set forth in the agreement, the agreement should include a carve out stating that this provision does not apply to claims for fraud and intentional misconduct.
• State that the parties are not required to arbitrate fraud or intentional misconduct claims. If the seller engaged in fraudulent or intentional misconduct, you will want to have your day in court rather than being required to appear before an arbitrator.
• Negotiate indemnification rights against the target’s shareholders. The definitive purchase agreement should require that not only the seller, but also the target’s shareholders, make all representations and warranties. The agreement should also include a provision allowing the buyer to seek indemnification against the target’s shareholders without limitation on their exposure for breaches of the representations and warranties. Moreover, the damages for fraud should not be capped at the consideration each shareholder received at closing.
• Require a “bring down” certificate. The buyer should require that the seller, by a duly authorized officer, reaffirm the company’s representations and warranties at closing. A bring down certificate protects the buyer because it requires that the seller attest to the company’s representations and warranties twice and explicitly provides that the representations and warranties were true not only as of the effective date of the definitive purchase agreement, but also as of the closing date.
There are also provisions that buyers should attempt to exclude, including a “no reliance” clause, and an “anti-sandbagging” provision. The former is a clause in which a party acknowledges that it has relied only on those representations and warranties explicitly set forth in the four corners of the definitive purchase agreement and that it will not rely on any other representations or warranties made. Thus, any fraudulent representations made outside of the purchase agreement would be excluded. An “anti-sandbagging” provision provides that, if the seller can prove that the buyer knew about misrepresentations made by the seller before closing, the buyer cannot seek damages.
Absent a carefully drafted definitive purchase agreement, investors will have far fewer remedies and will have to prove fraud to obtain damages over and above those negotiated. Fraud is a very high standard to meet, and investors may find themselves with only public policy arguments to recover the millions of dollars lost.
James Hill is a managing partner and executive committee chair at Benesch, Friedlander, Coplan & Aronoff LLP. He is a member of the firm’s Corporate and Securities Practice Group and its Private Equity Group. Julie Price is an associate at the firm that works in its private equity and venture capital practices, while Jayne Juvan is also an associate in the firm’s health care practice.
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