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public policy of this State will not permit the Seller to insulate itself from the possibility that the sale would be rescinded if the Buyer can show either: 1) that the Seller knew that the Company's contractual representations and warranties were false; or 2) that the Seller itself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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1. Posted by Jeff Lipshaw on February 28, 2006 @ 2:24 | Permalink
I can't tell either from Gordon's or Larry's post what the clause at issue actually said. But it strikes me this is a commonplace issue. Agreements have caps and baskets in the indemnification clause all the time; indeed there are rules of thumb - say, a 1% percent of purchase price non-clawback basket and a 25% of purchase price cap. Even in a sophisticated deal, you often sit back and wonder (when you have a moment) whether that really means that the seller has a free pass on lying up to the amount of the basket (or in this case, above the cap).
I'm very curious to see the language that defines a "misrepresentation." Obviously, the failure of a representation in a stock purchase agreement is a misrepresentation, but it can be one of at least three things: (1) a deliberate lie, (2) an innocent error, or (3) depending on when the representation is to be effective (e.g. "as of the signing and the closing") one that is true when made but becomes false. It's also commonplace among working lawyers to say to each other during a negotiation that you can't disclaim fraud. Which leads me to the conclusion that unless the language really does exculpate a deliberate falsehood, Chancellor Strine got it about right. You are contracting around everything except a deliberate baldfaced lie (instance no. 1), in which case you recognize that the remedy will be extra-contractual.
What you do see are different ways of trying to bell this particular cat. Organizations are big and dispersed; you define knowledge to be that of a few particular officers. So buyers react by saying they want an obligation of due inquiry. Or you negotiate over an "anti-sandbag" clause. That is, if it turns out the representation is false, but the buyer saw something in due diligence that gave it actual knowledge of the falsity of the rep, then there is exculpation for the seller.
All of those things may in hindsight look like the exculpation of lying, but I don't think they are meant to be. They are ways of trying to allocate the cost of uncertainty more and more finely, but I don't think generally to the point that you give a release for a lie.
2. Posted by Gordon Smith on February 28, 2006 @ 14:11 | Permalink
You asked for the limiting provision, but it is not quoted in the case. This is the relevant section of the opinion:
The Seller also put its wallet behind the Company's representations and warranties to a defined extent. This was accomplished through a promise by the Seller to indemnify the Buyer if the Company's representations and warranties were incorrect or in other similar, broadly-defined circumstances. Section 9.1 of the Agreement sets forth this obligation. It states in pertinent part at subsection (a) that:
[T]he Selling Stockholder agrees that, after the Closing Date, the Acquiror and the Company and ... each controlling shareholder of the Acquiror or the Company ... shall be indemnified and held harmless by the Selling Stockholder from and against, any and all claims, demands, suits, actions, causes of actions, losses, costs, damages, liabilities and out-of-pocket expenses incurred or paid, including reasonable attorneys' fees, costs of investigation or settlement, other professionals' and experts' fees, and court or arbitration costs but specifically excluding consequential damages, lost profits, indirect damages, punitive damages and exemplary damages ... to the extent such Damages ... have arisen out of or ... have resulted from, in connection with, or by virtue of the facts or circumstances (i) which constitute an inaccuracy, misrepresentation, breach of, default in, or failure to perform any of the representations, warranties or covenants given or made by the Company or the Selling Stockholder in this Agreement...
Section 9.1(c), however, goes on to limit the aggregate liability of the Seller for conduct covered by § 9.1(a) to the amount of the escrowed Indemnity Fund, which was established to be $20 million in § 2.4(b). This limitation is part of a very textured subsection that also permits the Buyer to seek damages for breaches of representations and warranties, without reference to materiality qualifications placed on them in the bring-down clause-that is, the clause of the Agreement that brings the representations and warranties down from the time of signing to the time of closing in the form of closing conditions. In other words, through the Indemnity Claim process, the Buyer clawed back the materiality qualifiers the Company and Seller extracted on the representations and warranties for purposes of closing.
The Stock Purchase Agreement also addresses the exclusivity of the Indemnity Claim provisions of the Agreement. To that end, § 9.9(a) (the “Exclusive Remedy Provision”) provides:
Except as may be required to enforce post-closing covenants hereunder ... after the Closing Date the indemnification rights in this Article IX are and shall be the sole and exclusive remedies of the Acquiror, the Acquiror Indemnified Persons, the Selling Stockholder, and the Company with respect to this Agreement and the Sale contemplated hereby; provided that this sentence shall not be deemed a waiver by any party of its right to seek specific performance or injunctive relief in the case of another party's failure to comply with the covenants made by such other party.
In addition, § 9.9(b) clearly states that “[t]he provisions of Article IX were specifically bargained for and reflected in the amounts payable to the Selling Stockholder in connection with the Sale pursuant to Article II.” The provisions of Article IX include the Exclusive Remedy Provision, the Indemnity Claim provision, and the Indemnity Fund provision.
3. Posted by Jeff Lipshaw on February 28, 2006 @ 18:33 | Permalink
That all strikes me as a very typical indemnity clause, as well as a not-too-unusual cap. I'm not too sure on the materiality claw back; one of the arguments when you got a basket as seller was that there OUGHT to be a clawback on individual rep materiality exceptions; otherwise seller gets a double dip.
What was the procedural posture? It sounds to me like the seller was trying to argue there was no fraud claim as a matter of law, using fairly standard M&A language as somehow exculpatory. I think a well-pled fraud claim (i.e., stated with the specificity required by FRCP 9(b)) survives a motion to dismiss, and if there is a genuine issue of fact, goes to trial.
So it still seems to me a relatively unremarkable - and sound - conclusion.
4. Posted by Gordon Smith on February 28, 2006 @ 20:23 | Permalink
Jeff, I wasn't suggesting that there was anything atypical about the indemnity clause or the cap, and I can see why Vice Chancellor Strine would rule as he did. As I noted in the original post, this is a close case, and he treated it that way.
As you surmise, it was an opinion on a motion to dismiss, and the seller was arguing that the buyer should not get recission.
You keep asking me about the case. Don't you have Westlaw access?
5. Posted by Jeff Lipshaw on March 1, 2006 @ 3:21 | Permalink
You are right; I was being lazy and reacting to the posts rather than read the case.
I confess to a personal stake here. I was the general counsel of Great Lakes who permitted one of the cases Strine distinguishes to go forward (I did not negotiate the underlying contract; that was my predecessor). I do now see the line Strine was trying to take. I think there is a broader jurisprudential issue, which is that this case is, at least in my mind, indistinguishable from some of the previous cases (at least the one with which I am unfortunately too familiar).
I can see the logic behind the enforcement of the non-reliance clause as to affirmative non-contractual representations. What the parties are really saying is: "look, there may be circumstances later in which it is your linterest to claim that I lied so you can get a fraud remedy and vitiate our negotiated cap on damages. We hereby agree that you ONLY relied on what is in the agreement." So Strine takes that at its word and goes back to the agreement. Except there he has already said there is no basis for reading the word "misrepresentation" as meaning only innocent representation. Having rejected language as a basis for carving out affirmative lies from the exclusive remedy provision, he has no place to go but the overlap of law and morality.
Here are three reactions in no particular order:
1. I agree with your comment about trying to distinguish intra- and extra- contractual lies. He IS trying to walk the non-reliance line.
2. A crafty lawyer (see Great Lakes!) ought to be able to avoid the "non-reliance" issue for fraud by casting the fraud as an omission and not a misrepresentation. Reliance is not an element of an omission claim. The trick is then coming up with the duty to disclose, because you can't have a fraudulent omission without such a duty. So you go back to the contract, or even some of the statements to which you gave the non-reilance promise and argue the "half-truth" duty: that is, if you had said nothing, I would be out of luck, but by saying part of the truth, you assumed a duty to tell the whole truth.
3. In the Great Lakes case, the facts were almost indistinguishable from these (it seems to me, but I recognize I am not dispassionate about this - you can take the boy out of advocacy, but you can't take advocacy out of the boy). We were left with a negotiated cap that was very low. We argued there was a breach of the "no material adverse change in the business" clause, which did survive motion practice because there was no scienter aspect to it. Moreover, we argued that the no MAC representation was more than an innocent mispresentation, because unbeknownst to us, the seller had put in motion certain market dynamics that actually caused the MAC, and failed to disclose them. Hence, we had a breach of contract count, and a fraud claim that really sounded in half-truth omission. So it seems to me we should have been able to proceed either (a) under Strine's logic, because the misrepresentation was in the contract, or (b) on the theory that the non-reliance clause was irrelevant because it was an omission case.
So (1) I still agree he got to the right place, and (2) I understand your reaction to the distinction, and (3) I am sympathetic to the jurisprudential issue he tries to address: that the law as model simply cannot be fine-tuned to the subtleties of conflicting and paradoxical values that manage to show up in real life.
6. Posted by Frank Snyder on March 1, 2006 @ 15:37 | Permalink
Seems to me that (from the discussion) the question isn't all that close. We're dealing with a sophisticated party who apparently deliberately released the other party for liability for lies. In that case, why should the machinery of the state get wound up to protect it? It could have protected itself by putting a clause in the agreement providing for liability for deliberate lies. If the other party refused to agree to that, the first party would have the option of going forward or not, but would know exactly where it stood. I have very little sympathy for commercial parties who sign anything to get a deal done and then come whining to the courts. And I'm very dubious about the ability of judges to decide after the fact what were incorrect statements and what were "lies."
7. Posted by Gordon Smith on March 3, 2006 @ 9:08 | Permalink
I have been crazy busy here over the past couple of days, but in my spare moments, I have been pondering this issue. Frank lays out more succinctly than I the case for strict interpretation of the contract, but I do not take that position with as much gusto as he. A couple more thoughts ...
My original post was not intended to endorse sharp dealing, but to suggest that the possibility of judicial error in ex post examinations of alleged fraudulent misrepresentations has the potential to undo the original negotiations. The value of strict interpretation in this sort of case is that it might provide future contracting parties with a greater incentive to get the contract right in the first place. Like many commentators (and, if I read the opinion correctly, like Vice-Chancellor Strine), I am troubled by parties who are sloppy on the front end, then hope that courts can make up the difference.
On the other hand, living in an eat-what-you-kill world is not so great, either. Courts have developed all sorts of rules to help people who have not adequately bargained ex ante (good faith and fair dealing, fiduciary duties, promissory estoppel, etc.) Generally speaking, I think the world is a better place because of those rules, even though their existence can lead to sloth on the front end.
Whatever your position on this sort of judicial lifeguarding, the fact that it has been common in exculpation cases forced Vice Chancellor Strine to confront the possibility that strict interpretation would be improper. By drawing the line at intentional falsity, I suspect that he went as far towards strict interpretation as he thought the precedents would allow.
On balance, I still think I would rather live in a world of strict interpretation in exculpation cases, but given the precedent, it's hard to fault Vice Chancellor Strine for deciding Abry as he did.
8. Posted by Jeff Lipshaw on March 3, 2006 @ 16:24 | Permalink
I agree with both Frank and Gordon about post-dealing whining, but I actually don't think that's a legal issue as much as it is a social or cultural issue. Claire Hill and Christopher King have a neat article (don't have the cite handy) on why it is that German contracts are shorter and there is less litigation.
On the other hand, the idea that disputes arise out of sloppy or incomplete drafting on the front end was discussed by Posner in a recent Texas Law Review article entitled The Law and Economics of Contract Interpretation. I think that adopts a rational actor view of the world (not surprising), and I wrote a response both to Posner and the various economic attempts to square the circle of language in The Bewitchment of Intelligence (78 Temp. L. Rev. 99 (2005). I was trying to reconcile my casually empirical observations of how the world worked against the rational actor theory.
I have since discovered that the eminent British legal philosopher P.S. Atiyah made a similar (pithier and probably a lot better) observation in Promises, Morals, and Law: "[M]any judges have rejected the idea that exonerating circumstances of this nature are in any sense genuine 'implications' of what the parties intended. Too often, the problems which have beset the contract arise precisely because the parties did not foresee the events which have occurred, and they did not, therefore, have any relevant intentions at all. It is true, of course, that a person may use language intended to cover (or exclude) a general class of things without necessarily adverting to each known example: 'Someone says to me: "shew the children a game." I teach them gaming with a dice, and the other says, "I didn't mean that sort of game."'" That's what I think most contract litigation is about.
With all due respect to my friend and mentor Frank, I have negotiated deals with lawyers who want to write contracts in which you do things like put in explicit statements that one has not lied, or the negative pregnant to every positive statement, and a deal that should have cost $100,000 in legal fees ends up costing $500,000.
All of this is to say that I don't think the problem is assiduousness or preparation or foresight. It is the problem that language and the law are blunt instruments that are often incapable of drawing the fine line of the implicit understanding. We are a rational and litigious culture in which consensus is less important than being right, so we try to reach the RIGHT answer, instead of working it out like the Europeans do.
9. Posted by John Coates on March 18, 2006 @ 11:30 | Permalink
Interesting discussion. A few thoughts:
1. One of Strine's points not directly engaged by Gordon and Frank (or Larry on his blog) is that the contract did not in fact say, in so many words, "our indemnity clause applies to intentional lies, too." Rather, it covered "misrepresentations."
2. A tension in the opinion is that first Strine interprets the clause in the alleged liar's favor, by construing "misrepresentation" to encompass intentional fraud, but then Strine goes on to argue (footnote 85) as follows:
"Although I agree with the Seller’s reading of the Agreement, the Agreement does not explicitly state that the Buyer was waiving the right to rescind even if the Seller and Company lied about contractual representations."
This is Strine's principal response to Larry's and Gordon's argument that Strine's refusal to permit lies inside the contract to be limited by the indemnity clause is inconsistent with precedent (which Strine endorses) that liability for lies outside the contract can be eliminated by a sufficiently clear merger clause and waiver of representations not stated in the contract.
3. An implication of 2. is that if the contract had said, in so many words, "this indemnity clause is meant to cover intentional lies, too," then it might have been enforceable. As I say, this seems in tension with the public policy reasoning elsewhere in the opinion.
4. This also suggests that Strine's interpretation of "misrepresentation" may be overly generous to the Seller. Frank suggests that Buyer could easily have insisted on an exception to the Indemnity Clause for intentional lies. But Seller, too, could easily have insisted on adding "intentional or negligent" before the word "misrepresentation." Such arguments are almost always flippable, at least in reported cases, where the clause in question usually has some degree of ambiguity about it. Presumably, the ambiguity arises because few Sellers want to say, in so many words, "we want you to understand that we may have lied to you even within the four corners of the agreement, and we want you to agree we will only be liable for a small percentage of the purchase price if we did lie."
5. An alternative way for a seller to get to the same place (i.e., no liability for lying) is for the contract to contain (a) no representations, (b) a merger clause, and (c) a clear waiver of prior or contemporaneous oral or external representations. If the buyer insists of there being some specified indemnity for, e.g., failure of certain facts to be true, one could simply contract for a payment from seller to buyer conditional on the inverse of those facts. That is, don't use representation of a fact plus indemnity, use a covenant conditioned on a fact that is not represented by anyone, but simply used as a condition. There would then be the sought-for risk-allocation, without any risk that a representation within the contract could be the basis for a fraud claim.