Private Equity

There are few things more fundamental to the sell-side private equity deal practice than, to the maximum extent possible, (1) establishing a contractual cap on post-closing liability for breaches of reps and warranties made by the target company or the selling stockholders and (2) contractually exonerating/releasing the selling entity’s human agents and nonparty affiliates from any exposure to tort liability arising from or related to the transactions that are the subject of the private company acquisition agreement. Maximizing the effectiveness of contractual limitations on the liability of the selling stockholders to an agreed-upon cap (and on the exoneration/release from liability for the selling entity’s human agents and nonparty affiliates) involves (a) recognizing the common law’s imposition of personal liability on the human agents of corporations and limited liability companies for certain types of misrepresentations made in the sale of a target company, even when such misrepresentations were made solely on behalf of and for the benefit of the selling entity, (b) understanding the public policy limits courts have imposed on the degree to which a contract can limit remedies in the event of certain types of fraud claims, (c) the effective use of three independent contractual provisions that each accomplish a distinct objective: a non-reliance clause, an exclusive remedy clause and a nonrecourse clause and (d) avoiding undefined (or too-broadly defined) fraud carve-outs that can override and significantly extend the built-in public policy carve-outs. A recent Delaware Superior Court decision, Surf’s Up Legacy Partners, LLC v. Virgin Fest, LLC, 2021 WL 117036 (Del Super. Jan. 13, 2021), is a reminder of the consequences to the sell-side of failing to consider and apply each of these principles in private company acquisition agreements. 

Surf’s Up Legacy Partners involved the acquisition of virtually all of the assets of a selling entity by the buyer. Following the closing of the acquisition, the buyer alleged that the human managers of the limited liability company seller had engaged in both intra-contractual and extra-contractual fraud, by failing to disclose certain material liabilities related to the assets being purchased. The human management defendants sought to dismiss these claims by pointing to two provisions of the Asset Purchase Agreement (“APA”): a nonrecourse clause and an exclusive remedy provision. 

The exclusive remedy provision contained a carve-out for “Fraud,” which was defined as “any false representation, misrepresentation, deceit, or concealment of a fact with the intention to deceive, conceal or otherwise cause injury.” The court suggested that as thus defined, it could have just as easily been left undefined; indeed, the court declared that this definition was “virtually interchangeable with common law fraud.” Thus the definition did nothing to limit the sources of alleged misrepresentations that could be the basis for a fraud claim (i.e., both intra-contractual and extra-contractual sources of purported misrepresentations were available), although the defined term “Fraud” did appear to at least limit the degree of culpability required to establish such a claim—i.e., it required an actual “intention to deceive, conceal or otherwise cause injury.” And because the APA did not contain a non-reliance clause, the entire dog’s breakfast of potential extra-contractual fraud claims were available to the buyer in any event—i.e., even had the Fraud carve-out in the exclusive remedy provision purported to limit fraud claims to those exclusively premised upon the bargained-for contractual representations set forth in the APA, it is far from clear that would have actually so limited such claims. Furthermore, the defined Fraud carve-out not only carved out Fraud by a “Party” to the contract, but also the Fraud of any “Person,“ including specifically “any Fraud by an officer or manager of any Seller or Buyer in connection with the consummation of the transactions contemplated by this Agreement.”

The nonrecourse provision, on the other hand, contained no Fraud carve-out, and was specific in stating that the buyers were to have no recourse to the managers of the selling entity for any claims arising under or related to the APA (“whether in contract or in tort”). As a result, the human manager defendants asserted that the nonrecourse clause trumped the exclusive remedy clause’s Fraud carve-out. Not so said the court—the exclusive remedy provision stated that “nothing herein shall … preclude any party from seeking any remedy against any Person based upon Fraud by any other Party.” And according to the court, the “herein” referred to was the entire APA, not just the exclusive remedy provision itself; thus, the exclusive remedy provision’s Fraud carve-out trumped the non-recourse provision: “while the parties generally agreed the No Recourse Provision would bar ‘tort’ claims against the Managers, they also expressly agreed the APA would not bar the bringing of fraud claims.” But importantly for our purposes, the court went further and stated that the parties “could not have contacted otherwise … [because] Delaware courts refuse to enforce contracts purporting to condone—or at least insulate—intentional fraud.” The court thus suggested that, even if the exclusive remedy provision’s fraud carve-out had not been deemed to have trumped the nonrecourse clause’s bar on tort claims against nonparty human agents of the entity parties, an intentional fraud claim could still have been brought against the human managers of the selling entity party to the APA based on Delaware public policy.

The court’s suggestion that a nonrecourse clause was incapable of insulating a human nonparty agent of a selling entity from liability for an intentionally fraudulent misrepresentation should not surprise anyone familiar with then Vice Chancellor Strine’s careful demarcation, in Abry Partners V, L.P. v. F&W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006), of the limits of exclusive remedy provisions (of which a nonrecourse clause is simply a specific type—i.e., one that is designed to exclude all remedies against nonparties to the agreement,^[1] rather than simply to limit the available remedies generally to a capped indemnification). But Surf’s Up Legacy Partners provides an opportunity to remind sell-side deal professionals and their advisors of the basic rules of the road required to effectively limit liability and mitigate potential blow-back to the private equity firm, its partners or deal professionals. Accordingly, here are those rules of the road:

• Entities can only act through human agents. Those human agents may bind their entity principals by the actions they take, but they nevertheless have personal liability for those actions if they constitute a tort. And this personal liability exists even when the entity is being operated properly and there would be no basis for “piercing the veil” of that entity. Thus, deal professionals have potential exposure to personal liability for misrepresentations alleged to have been made by or under the direction of the deal professional during the negotiation of the sale of a portfolio company, even when they are acting solely on behalf of and for the sole benefit of the portfolio company or the private equity firm owner. The portfolio company or the private equity firm owner can also be held liable for a misrepresentation alleged to have been made by a deal professional acting with the scope of their authority.^[2]
• Potential misrepresentations that can give rise to this potential tort liability for both the deal professional and the portfolio company or private equity firm owner can be premised both upon statements made outside the written acquisition agreement (so-called “extra-contractual” representations) and statements made within the written acquisition agreement (so-called “intra-contractual” representations).
• In Delaware, a well-crafted and properly placed non-reliance clause can effectively eliminate the specter of claims premised upon purported “extra-contractual” representations. This is because reliance is a necessary element of a claim based upon an alleged fraudulent misrepresentation. If the buyer disclaims any reliance on statements made outside the contract, then, in those states like Delaware that recognize the effectiveness of a non-reliance clause, all such claims are subject to dismissal.^[3] Neither a standard nonrecourse clause, nor a standard exclusive remedy provision, can achieve this objective because they typically do not purport to have the buyer disclaiming reliance upon purported statements not contained within the four corners of the written acquisition agreement.^[4] Unlike exclusive remedy provisions and nonrecourse clauses, there do not appear to be any Delaware public policy exceptions to the effectiveness of a well-crafted and properly placed non-reliance clause. There was no non-reliance clause in the APA being considered in Surf’s Up Legacy Partners; thus both extra-contractual and intra-contractual fraud claims were at play.
• Contrary to popular belief, a claim of fraudulent misrepresentation does not require proof that the speaker deliberately spoke a falsehood. Fraud claims can be premised upon a variety of culpable states of mind. Indeed, claims of fraud can be “easy to allege, hard to dismiss on a pre-discovery motion, difficult to disprove without expensive and lengthy litigation, and highly susceptible to the erroneous conclusions of judges and juries.”^[5] Sell- side private equity players seek to eliminate or mitigate the potential for these claims not because they intend to exonerate themselves from deliberately misleading a buyer respecting the bargained-for package of reps and warranties that form the predicate for the deal they made, but to avoid after-the-fact accusations and efforts to remake that deal based upon assertions of things purportedly said in negotiations that were not in fact made part of that bargain. Most sponsors understand the public policy requirements and are willing to accept liability imposed pursuant to that public policy because it is limited to deliberate lying respecting the specific, bargained-for package of reps and warranties.
• In Delaware, an exclusive remedy provision can be drafted to eliminate all fraud claims premised upon any culpable state of mind, except one: Delaware public policy does not permit the enforcement of an exclusive remedy provision — the effect of which would be to eliminate “the [s]eller’s exposure for its own conscious participation in the communication of lies to the [b]uyer” in the written agreement itself.^[6] And that “conscious participation in the communication of lies” in the written agreement can occur either where “the [s]eller knew that the [portfolio] [c]ompany’s contractual representations and warranties were false” or where “the [s]eller itself lied to the [b]uyer about a contractual representation and warranty.”^[7] But, an exclusive remedy provision can “allocate the risk of intentional lies by the [portfolio] [c]ompany’s managers to the [b]uyer” (as long as the seller is unaware of such lies by the portfolio company managers), and an exclusive remedy provision can likewise eliminate liability for “reckless, grossly negligent, negligent, or innocent misrepresentations of fact” by the seller or the portfolio company within the written acquisition agreement.^[8]
• Contractual fraud carve-outs can expand the limited public policy carve-out so that it is not a carve-out solely for the conscious participation of a person in the communication of lies in the written agreement, but covers other less egregious mental states, potentially exposes innocent selling parties to liability based on the actions of culpable selling parties, and potentially exposes all selling parties to both extra-contractual and contractual representations made or purportedly made by anyone with apparent authority to act on behalf of the selling parties notwithstanding the non-reliance clause.^[9]
• There is a line of Delaware cases predating Abry Partners that specifically addresses the scope of nonrecourse clauses commonly found in bond indentures. Those cases uniformly held that those nonrecourse clauses did not exonerate directors or officers of corporate issuers for fraud or other tort claims.^[10] Courts in other jurisdictions have been similarly reluctant to enforce a standard nonrecourse clause to insulate an officer, director or nonparty affiliate from liability for its participation in intentionally fraudulent conduct.^[11] Nonrecourse clauses used in most private equity deals, however, are substantially more expansive than the earlier bond indenture provisions and typically specify that both contract and tort claims are covered by the exoneration and release set forth in the nonrecourse provision.^[12] Nonetheless, in light of the public policy limitations on exclusive remedies provisions created by Abry Partners, and Surf’s Up Legacy Partner’s suggestion that a nonrecourse clause is similarly limited and cannot exonerate nonparty agents and affiliates that participate in intentional fraud, one should not place too much reliance on the protection afforded by a nonrecourse clause alone.^[13] 
• But neither an exclusive remedies provision, a nonrecourse clause, nor a non-reliance clause should be used alone or in any combination that does not utilize all three. Thus, while a nonrecourse clause may not eliminate the full specter of personal liability for all claims based upon fraud, when combined with a non-reliance clause, that liability can be limited so that it only relates to intra-contractual claims based on the contractual reps and warranties and not extra-contractual claims of fraud (regardless of the alleged degree of culpability). A well-crafted and properly placed non-reliance clause eliminates (for the parties, their deal professionals and nonparty affiliates^[14]) the dog’s breakfast of assorted claims regarding purported statements alleged to have been made that were not part of the specifically bargained-for rep and warranty package set forth in the acquisition agreement. And an exclusive remedy provision, subject to the built-in public policy exception, or a contractual Fraud carve-out that is not too broadly defined, can effectively preclude intra-contractual fraud claims based upon degrees of culpability that do not rise to the level of deliberate misrepresentations of fact respecting the bargained-for package of reps and warranties set forth in the acquisition agreement or against persons other than those who actually engaged in such fraudulent behavior.

Remember, each clause in the acquisition agreement works together with all other clauses, and when it comes to mitigating the risks of untethered fraud claims, the non-reliance clause, the nonrecourse clause and the exclusive remedies provision all need to work together against knowledge of the public policy restrictions on their full effectiveness.