Private Equity

A Wake-Up Call for the Private Equity Seller’s Proper Placement of the Non-Reliance Clause: Knowing what to say and how to say it may not be enough; you also need be certain where it is being said and who is saying it.

Ken Adams, a contract drafting guru with a well-read blog, recently noted, in the Law Society Gazette, that contract drafting is a function both of knowing what to say, as well as knowing how to say it.  While that may sound simple, it’s not.  Good contract drafting is an acquired skill, requiring training, practice and constant vigilance in staying current with the reported decisions of the courts that might be called upon to interpret the agreements you draft.  A recent example of a case that falls into the category of reported decisions meriting a contract drafter’s attention is the Delaware Court of Chancery decision in FdG Logistics LLC v. A&R Logistics Holdings, Inc., decided on February 23, 2016.  This case once again reminds the private equity deal world of just how potent post-closing fraud claims can be in eviscerating the bargained-for caps on indemnification contained within the purchase and sale agreement.

But to aid our review of that decision, another event occurring a little over two weeks prior to this decision is worthy of mention.  On February 8, 2016, Amazon Web Services, in a nod to popular culture, updated their standard service terms to add (to Section 57.10) a “zombie apocalypse clause.”  The updated clause removes certain restrictions on the use of one of AWS’s products in the event of a “widespread viral infection transmitted via bites or contact with bodily fluids that causes human corpses to reanimate and seek to consume living human flesh, blood, brain or nerve tissue.”

While AWS’s reference to a zombie apocalypse in its updated standard service terms is clearly farcical, it turns out that there is a surprising connection between the fictional, flesh-eating zombie, and the very serious post-closing fraud claim.  Just as the fictional zombie can threaten the workings of civilized society (if not human extinction), the mere allegation of a post-closing fraud claim, in the absence of an effective contractual defense, can wreak havoc upon the private equity seller seeking to make distributions to its limited partners based upon the bargained-for caps on indemnification set forth in the written purchase and sale agreement (see this previous Weil blog posting for a fuller discussion of this reality for the private equity seller in connection with a review of another recent Delaware case on this subject).  And it turns out that the purported means of eliminating a fictional zombie is similar to the contractual means of eliminating the very real, and pervasive, post-closing fraud claim based upon alleged extra-contractual representations.  Both require the skillful use of a specialized weapon aimed at exactly the right spot.

The problem with zombies is that they are really scary, they keep on galumphing toward their intended victim despite receiving what would be a fatal blow to any living being, and they technically can’t be killed (after all, they are already dead).  According to Zombiepedia, the only way to neutralize a zombie is to deliver a decisive blow to its brain stem where whatever causes it to continue to function can apparently be eliminated (and only certain weapons can apparently deliver such a blow, and skill is required for their use).  Eliminating post-closing fraud claims based on alleged extra-contractual representations (which can be fictively recreated from the disputed memories of who said what to whom) is like that too.

The problem with extra-contractual fraud claims is that they have “proven to be tough to define, 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” (for the uninitiated, the following articles are available here and here for a fuller discussion of the problem and its potential solutions).  To eliminate the specter of post-closing fraud claims based on alleged extra-contractual representations, you have to deliver (in your written agreement) a skilled and decisive blow to one of the required elements necessary to sustain a cause of action for common law fraud so that they can in fact be dismissed without the necessity of a trial.  And what is that element?  In other words, what is the brain stem of an extra-contractual fraud claim that must be severed to eliminate it?  Well-trained private equity lawyers know that the brain stem of an extra-contractual fraud claim is the requirement that a plaintiff prove that it “justifiable relied” upon the alleged extra-contractual representations.  And skillfully severing that particular brain stem is simply a matter (in many, but not all, states) of requiring the buyer to state clearly, in an effective non-reliance clause, that the buyer did not rely upon any extra-contractual statements or matters, but only upon the bargained-for contractual representations and warranties specifically set forth in the written agreement.  But apparently not all sellers approach the severing of that particular brain stem in the required manner.  Indeed, the various ineffective means by which sellers are simply slapping at, but not neutralizing, the zombie-ish fraud claim are legion.

A fairly common practice to attempt to eliminate an extra-contractual fraud claim, among some sellers, is to add to the last of the series of representations and warranties, made by the company/seller, a final representation by the company/seller that is entitled something like, “No Other Representations.”  The “No Other Representation” section of the article that contains the company/seller’s representations and warranties, and which begins with the statement that “the [Company/Seller] hereby represents and warrants as follows,” typically contains an elaborate disclaimer of the existence of any other representations other than those set forth in the previous sections of that article of the agreement.  A good example of such a clause, tacked onto the end of the article containing the company/seller’s representations and warranties, is the following Section 5.27, which was examined by the Delaware Court of Chancery in the FdG Logistics case

EXCEPT AS EXPRESSLY SET FORTH IN THIS ARTICLE 5, THE COMPANY MAKES NO REPRESENTATION OR WARRANTY, EXPRESS OR IMPLIED, AT LAW OR IN EQUITY AND ANY SUCH OTHER REPRESENTATIONS OR WARRANTIES ARE HEREBY EXPRESSLY DISCLAIMED INCLUDING ANY IMPLIED REPRESENTATION OR WARRANTY AS TO CONDITION, MERCHANTABILITY, SUITABILITY OR FITNESS FOR A PARTICULAR PURPOSE. NOTWITHSTANDING ANYTHING TO THE CONTRARY, (A) THE COMPANY SHALL NOT BE DEEMED TO MAKE TO BUYER ANY REPRESENTATION OR WARRANTY OTHER THAN AS EXPRESSLY MADE BY THE COMPANY IN THIS AGREEMENT AND (B) THE COMPANY MAKES NO REPRESENTATION OR WARRANTY TO BUYER WITH RESPECT TO (I) ANY PROJECTIONS, ESTIMATES OR BUDGETS HERETOFORE DELIVERED TO OR MADE AVAILABLE TO BUYER OR ITS COUNSEL, ACCOUNTANTS OR ADVISORS OF FUTURE REVENUES, EXPENSES OR EXPENDITURES OR FUTURE FINANCIAL RESULTS OF OPERATIONS OF THE COMPANY UNLESS ALSO EXPRESSLY INCLUDED IN THE REPRESENTATIONS AND WARRANTIES CONTAINED IN THIS ARTICLE 5, OR (II) EXCEPT AS EXPRESSLY COVERED BY A REPRESENTATION AND WARRANTY CONTAINED IN THIS ARTICLE 5, ANY OTHER INFORMATION OR DOCUMENTS (FINANCIAL OR OTHERWISE) MADE AVAILABLE TO BUYER OR ITS COUNSEL, ACCOUNTANTS OR ADVISORS WITH RESPECT TO THE COMPANY.

Not bad right?  Indeed, in a different section of the agreement it might have worked, at least in Delaware.  For the skilled private equity lawyer, of course, this is less than an ideal disclaimer of reliance, even if made by the buyer. What is the missing magic word or bullet (the brain stem severing blow if you will) that many courts require to summarily dispatch a post-closing fraud claim based upon alleged extra-contractual representations?  The missing word, of course, is rely or relied, as in “the buyer has not relied and will not rely upon any other representations and warranties.”  While recent Delaware cases suggest there are no magic words required in these provisions, best practice remains to nonetheless employ them, as striking the decisive blow is critical to summary dismissal of these claims.  But here the person making this disclaimer (even had it included the magic word or bullet) is not the buyer but the company/seller.  So, the zombie-ish fraud claim keeps on coming.  In other words, the right weapon may have been wielded, but the weapon was wielded in such a manner that the blow did not strike with appropriate force in the right place.

Amazingly, a quick examination of a portion of the publicly available private company acquisition agreements in the U.S. suggests that many sellers follow this same approach.  But, as this case demonstrates, this approach may prove ineffective in eliminating the post-closing fraud claim based upon extra-contractual representations.  An effective disclaimer of reliance upon extra-contractual representations must be made by the buyer in the article of the agreement where the buyer is making representations to the seller (or somewhere else in the written agreement where the speaking party is the buyer).

In this case, the buyer made common law fraud claims against the selling stockholders (and some of the private equity firm’s deal professionals) based upon alleged extra-contractual statements and omissions in the confidential information memorandum, management presentations, and other materials provided prior to the signing of the Merger Agreement (which were referred to by the court as the “Pre-Merger Materials”).  The sellers sought to dismiss these claims based on the above referenced Section 5.27 (along with a standard integration provision in Section 10.7), but the court said:

Here, … the critical language missing from Sections 5.27 and 10.7 of the Merger Agreement is any affirmative expression by Buyer of (1) specifically what it was relying on when it decided to enter the Merger Agreement or (2) that it is was not relying on any representations made outside of the Merger Agreement. Instead, Section 5.27 amounts to a disclaimer by the selling company … of what it was and was not representing and warranting. Moreover, the integration clause contained in Section 10.7 merely states in general terms that the Merger Agreement constitutes the entire agreement between the parties, and does not contain an unambiguous statement by Buyer disclaiming reliance on extra-contractual statements.

The difference between a disclaimer from the point of view of a party accused of fraud and from the point of view of a counterparty who believes it has been defrauded may seem inconsequential, like two sides of the same coin. The difference is critical, however, because of the strong public policy against fraud. As explained in Abry, the Court will not bar a contracting party from asserting claims for fraud based on representations outside the four corners of the agreement unless that contracting party unambiguously disclaims reliance on such statements. The language required to disclaim reliance may vary, … but the disclaimer must come from the point of view of the aggrieved party (or all parties to the contract) to ensure the preclusion of fraud claims for extra-contractual statements under Abry and its progeny. Because the language of Section 5.27 and 10.7 of the Merger Agreement does not contain this type of unambiguous anti-reliance disclaimer by Buyer, those provisions are not sufficient to preclude its common law fraud claim relating to the Pre-Merger Materials.

So, having carefully delineated the limited representations and warranties the sell-side was willing to make, and the limited remedies for breach of those representations and warranties for which the sell-side was willing to be responsible, the selling private equity stockholder, and many of the individual deal professionals involved in the negotiation of the merger, must now defend themselves, in a lengthy and expressive trial, against uncapped claims based upon extra-contractual statements and materials that were allegedly made or provided pre-signing, and which were not incorporated into the package of bargained-for contractual representations and warranties.  And this could all have been avoided, at least in Delaware, with a well-crafted disclaimer of reliance by the buyer (and it would not have hurt to have had a “no personal liability” provision to protect the individuals too—an article on that subject is available here).  So, knowing what to say and how to say it, also includes making sure that the proper who says it, and that can be accomplished by placing the well-crafted non-reliance clause in the proper where in your contract.  And it is important to note that, no matter how perfect the non-reliance clause and no matter how skillfully placed, in some states the non-reliance clause is simply ineffective against the extra-contractual fraud claim.  So choosing your governing law skillfully and thoroughly remains an important contractual defense as well.