Private Equity

In a recent Delaware Court of Chancery opinion, Vice Chancellor Glasscock had occasion to consider the meaning of the past-tense of an expletive commonly referred to as the “f-word,” which he described as “an Angelo-Saxon expression that, while generally unfit for publication, when used metaphorically has many meanings.”^[1] In the context in which that word was used in an email from a person that had apparently just discovered that a formal extension notice had not been given, and that the reverse break fee, which had been guaranteed by the firm of which he was a principal, may now be payable, Vice Chancellor Glasscock “was convinced … that the meaning the message attempted to convey was ‘prejudiced in the extreme.’”^[2] A more calm and polite way of conveying the message, of course, would have been to simple say:  “we are in an extremely difficult situation here.” But I digress.

An extremely difficult situation in which private equity sellers can sometimes find themselves involves a different “f-word” that also has “many meanings”—i.e., “fraud.” The term fraud is used all too often in post-closing disputes between sellers and buyers of private companies. And a claim of fraud, even if unjustified, can result in “prejudice in the extreme” against the private equity seller who seeks to or has distributed the sales proceeds to its limited partners (less whatever limited holdback or escrow to cover contractual indemnification was agreed). Indeed, “[f]raud … claims 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.”^[3] This is especially true when the fraud claim is based upon extra-contractual representations allegedly made during the negotiations of the deal, but which for whatever reason were never agreed to as express written representations to be incorporated in the acquisition agreement. And it is for that reason that the market has long-ago made “so-called” anti-reliance clauses a common feature of private company acquisition agreements. A well-crafted, true anti-reliance clause can eliminate (in many states) the specter of most extra-contractual fraud claims and permit dismissal of a case at the pleading stage. 

I call anti-reliance clauses “so called” because many clauses purporting to be anti-reliance clauses actually do not disclaim reliance upon any extra-contractual representations that may have in fact been made, but instead disclaim the existence of extra-contractual representations. And certain courts have found that distinction a critical one—failing to give effect to a clause that simply stated that there were no extra-contractual representations, while readily acknowledging that a clause disclaiming reliance upon any extra-contractual representations that had been made would have been effective.

In Italian Cowboy Partners, Ltd. v. Prudential Insurance Co. of America, the Texas Supreme Court famously recognized that distinction and held that an appropriate form or tense of the word “rely” is a critical element of an effective anti-reliance clause in defeating a claim based upon extra-contractual fraud. That is so, said the court, because “[t]here is a significant difference between a party disclaiming its reliance on certain representations, and therefore potentially relinquishing the right to pursue any claim for which reliance is an element, and disclaiming the fact that no other representations were made.”^[4] A strong dissenting opinion was mystified by the majority’s “preference for a disclaimer of reliance over a disclaimer of representations.”^[5] After all, according to the majority’s approach “a party who states (somewhat equivocally) that although representations may have been made, he is not relying on any of them, should be held to his word and his later claim of fraud foreclosed[,] [b]ut a party who unequivocally denies that any representations were made to induce his agreement, other than those in the agreement itself, may later sue for fraud on representations he denied were ever made.”^[6] But despite the dissents’ view, this distinction continues to be recognized in Texas. 

Because a significant number of private company acquisition agreements are governed by Delaware law, rather than Texas law, there may be a tendency to dismiss the importance of this distinction between “disclaiming the fact that no other representations were made,” and disclaiming reliance upon any other representations that were made. After all, when addressing the need for a specific formulaic approach to the language used in an anti-reliance clause, a prior Delaware Court of Chancery opinion definitively declared that “Delaware law does not require magic words.”^[7] Indeed, that opinion specifically noted that using terms like “disclaim reliance” was not required; rather “[l]anguage is sufficiently powerful to reach the same end by multiple means, and drafters can use any of them to identify with sufficient clarity the universe of information on which the contracting parties relied.”^[8] But the court did not hold that stating that no other representations had been made, without specifying that the only representations that were in fact relied upon were the contractual representations set forth in the written agreement, would be “sufficiently powerful” language.

And then, on March 6, 2019, in Heritage Handoff Holdings, LLC v. Fontanella, a federal district court sitting in Delaware, and applying Delaware law, sided with the Texas Supreme Court’s approach and determined that a clause that “disclaimed extra-contractual representations” was “not an anti-reliance provision” because the ‘[p]lantiff did not affirmatively promise not to rely upon such representations.”^[9] The clause determined not to be an anti-reliance clause in Fontanella, read as follows:

Except for the representations and warranties contained in Section 2 of this Agreement (including the related portions of the Shareholder Disclosure Schedule), the Shareholder, the Company and/or any other Person has not made or does not make any other express or implied representation, either written or oral, on behalf of the Shareholder or the Company (including any representation or warranty as to the accuracy or completeness of any information regarding the Company furnished or made available to Purchaser and its representatives, or in any form in expectation of the transactions contemplated thereby), or as to the future revenue, profitability or success of the Company, or any representation arising from statute or otherwise in law.^[10]

While deal counsel may be tempted to ignore the Fontanella decision because the court ended up dismissing the plaintiff’s common-law fraud claims for other reasons, or because the clause was written from the point of view of the seller rather than the buyer, caution would suggest otherwise. While “magic words” may not be required in Delaware, “sufficiently powerful” language is required. And “murky integration clauses, or standard integration clauses without explicit anti-reliance representations, will not relieve a party of its oral and extra-contractual fraudulent representations.”^[11] Rather, “[t]o be effective, a contract ‘must contain language that, when read together, can be said to add up to a clear anti-reliance clause by which the plaintiff has contractually promised that it did not rely upon statements outside the contract’s four corners in deciding to sign the contract.’”^[12]

Coincidentally, on March 15, 2019, in International Business Machines Corp. v. Lufkin Industries, LLC, the Texas Supreme Court declared effective a clear and unambiguous anti-reliance clause to defeat a claim of fraudulent inducement based upon extra-contractual representations.^[13] While there were actually two clauses that accomplished the same objective, I will only quote one of them to illustrate the difference between the effective clause here and the one declared ineffective in Fontanella:

In entering into this SOW, Lufkin Industries is not relying upon any representation made by or on behalf of IBM that is not specified in the Agreement or this SOW, including, without limitation, the actual or estimated completion date, amount of hours to provide any of the Services, charges to be paid, or the results of any of the Services to be provided under this SOW. This SOW, its Appendices, and the Agreement represent the entire agreement between the parties regarding the subject matter and replace any prior oral or written communications.^[14]

According to the court, this clause was a clear and unequivocal anti-reliance clause and effective in this context to defeat the extra-contractual fraud claims asserted by the plaintiff. And distinguishing Italian Cowboy, the court noted that:

We have held that a merger clause, standing alone, does not prevent a party from suing for fraudulent inducement. And similarly, a clause that merely recites that the parties have not made any representations other than those contained within the written contract is not effective to bar a fraudulent-inducement claim. But a clause that clearly and unequivocally expresses the party’s intent to disclaim reliance on the specific misrepresentations at issue can preclude a fraudulent-inducement claim.^[15]

Nothing is more fundamental to private equity deal practice than limiting the exposure of private equity sellers for post-closing claims. And exposure to the other f-word, whether though extra-contractual fraud claims (because of ineffective anti-reliance clauses or undefined fraud carve-outs), or claims based on less than deliberate and knowing misrepresentations (by the private equity seller itself) regarding the express, bargained-for representations set forth in the acquisition agreement (as a result of undefined fraud carve-outs), requires the most vigilance to avoid.^[16] Do not be prejudiced in the extreme by the other f-word. Avoid undefined fraud-carve-outs.^[17] And, use some form or tense of the word “rely” in your so-called anti-reliance clause (making sure the statement is coming from the buyer) to ensure that a court will have little trouble concluding that the “so-called” anti-reliance clause is an “actual” anti-reliance clause.^[18]