Two private equity firms negotiate a contract for the sale of a portfolio company. One of the firms makes a false representation in the contract,* but claims to be beyond the reach of the other party by virtue of a "non-reliance provision" in the contract. That provision purports to limit the selling firm's liability for any misrepresentation of fact in the contract to $20 million, but the other firm seeks recission of the contract. Is the limitation of liability enforceable?
After much analysis, Vice-Chancellor Strine narrowed the issue to this: whether "public policy intervenes to trump contractual freedom." Here is the money passage:
To the extent that the Stock Purchase Agreement purports to limit the Seller's exposure for its own conscious participation in the communication of lies to the Buyer, it is invalid under the public policy of this State. That is, I find that the public policy of this State will not permit the Seller to insulate itself from the possibility that the sale would be rescinded if the Buyer can show either: 1) that the Seller knew that the Company's contractual representations and warranties were false; or 2) that the Seller itself lied to the Buyer about a contractual representation and warranty. This will require the Buyer to prove that the Seller acted with an illicit state of mind, in the sense that the Seller knew that the representation was false and either communicated it to the Buyer directly itself or knew that the Company had.
Larry Ribstein thinks Vice-Chancellor Strine got it wrong, arguing that the "seller was reasonably contracting to avoid litigation risk." I agree.
As Larry and Vice-Chancellor Strine both recognize, this is a difficult case. On the one hand, Delaware is keen to enforce contracts as written. If you bargain for a promise, the court usually enforces it.
On the other hand, courts claim to abhor fraud, though that doesn't tell us much about where to draw the lines here. For example, Larry wonders why the court is willing to sanction lies made outside the contract by enforcing integration clauses, but is not willing to sanction lies made within the contract when liability for such statements is similarly disclaimed or expressly limited. Vice-Chancellor Strine offers a clever, if ultimately unpersuasive, justification:
To fail to enforce non-reliance clauses is not to promote a public policy against lying. Rather, it is to excuse a lie made by one contracting party in writing--the lie that it was relying only on contractual representations and that no other representations had been made--to enable it to prove that another party lied orally or in a writing outside the contract's four corners. For the plaintiff in such a situation to prove its fraudulent inducement claim, it proves itself not only a liar, but a liar in the most inexcusable of commercial circumstances: in a freely negotiated written contract. Put colloquially, this is necessarily a "Double Liar" scenario. To allow the buyer to prevail on its claim is to sanction its own fraudulent conduct.
The problem with this reasoning is obvious: the same reasoning would prevent the claim in this case.
This brings us to the nub of the problem: why is Vice-Chancellor Strine willing to allow the plaintiff here to proceed when he would not allow a plaintiff to proceed with a claim based on extra-contractual lies? He recognizes this as a difficult line-drawing problem, a tug of war between freedom of contract and fraud prevention. In the end, he claims to rely on a public policy borrowed from the law of business organizations:
In considering how to allocate the risk of misrepresentations consistent with public policy, I also consider our General Assembly's approach to exculpation in the case of business entities. In the corporate context, the General Assembly has permitted corporate charters to exculpate directors for liability for gross negligence. In the alternative entity context, where it is more likely that sophisticated parties have carefully negotiated the governing agreement, the General Assembly has authorized even broader exculpation, to the extent of eliminating fiduciary duties altogether.
Given these statements of policy by our General Assembly, it is appropriate for the judiciary in fashioning common law to give as much leeway to sophisticated business parties crafting acquisition agreements as is afforded to those who write the governing instruments of limited partnerships and limited liability companies. We should be reluctant to be more restrictive of freedom of contract than those elected by our citizens to write the statutory law.
He then proceeds to articulate the standard, quoted above, requiring the buyer to prove that the seller "acted with an illicit state of mind."
Which leaves me scratching my head. The public policy of Delaware provides that participants in an LLC can completely eliminate liability for breaches of fiduciary duties, and this somehow implies a public policy prohibiting enforcement of the exculpatory provision in this case?
Abry Partners V, L.P. v. F & W Acquisition LLC, 2006 WL 358236 (Del.Ch. 2006)
* This was the representation that was claimed to be breached:
The Company Financial Statements: (i) are derived from and reflect, in all material respects, the books and records of the Company and the Company Subsidiaries; (ii) fairly present in all material respects the financial condition of the Company and the Company Subsidiaries at the dates therein indicated and the results of operations for the periods therein specified; and (iii) have been prepared in accordance with GAAP applied on a basis consistent with prior periods except, with respect to the unaudited Company Financial Statements, for any absence of required footnotes and subject to the Company's customary year-end adjustments.
This representation was made by the portfolio company, not by the selling private equity firm, but the private equity firm certified the truthfulness and correctness of the company's representations.
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