Posted on:Europe, Features, Glenn West Musings, Insights, Legal Developments, U.K., What's New on the Watch?
A “dog’s breakfast” is one of my favorite British expressions. It can sum up a muddled mess of confusing and contradictory allegations and purported conclusions better than almost any other idiom in the English language. And it was just this expression that Vice Chancellor Glasscock recently used to describe a cacophony of alleged extra-contractual fraud claims made by a buyer of a business against the seller of that business.
In ChyronHego Corp. v. Wight, C.A. No. 2017-0548-SG, 2018 WL 3642132 (Del. Ch. July 31, 2018), Vice Chancellor Glasscock granted the seller’s motion to dismiss as to each and every one of the claims that comprised the buyer’s “dog’s breakfast of extra-contractual fraud claims” against the seller. Vice Chancellor Glasscock did so based upon the presence of a disclaimer of reliance made by the buyer in the stock purchase agreement. Forced as a result to rely solely upon the contractual representations specifically set forth in the stock purchase agreement, the buyer then alleged that all of the extra-contractual fraud claims actually constituted the breach of a specific contractual representation whereby the seller had represented that, since the balance sheet date, the purchased company had “conducted its business in all material respects in the ordinary course of business consistent with past practice.” How so? Because, said the buyer, making an extra-contractual misrepresentation during the negotiation of the stock purchase agreement was the antithesis of conducting business in the ordinary course. But Vice Chancellor Glasscock rejected this effort to “bootstrap” the extra-contractual claims on to the contractual claims.
Just a week earlier, in Flowshare, LLC v. GeoResults, Inc., C.A. No. N17C-07-227 EMD CCLD (Del. Super. July 25, 2018), Judge Davis of the Delaware Superior Court specifically rejected a motion to dismiss a claim of extra-contractual fraud by the seller of a business against the buyer of that business based upon an alleged pre-contractual promise made by the owner of the buyer that he personally would cover any shortfall in the purchase price payable to the seller; i.e. that he would be “personally on the hook for these obligations, in addition to the companies [he] own[s].” There was no specific contractual representation contained in the asset purchase agreement to this effect, and the buyer’s owner was not an individual signatory to the asset purchase agreement. So, why was the extra-contractual fraud claim not dismissed in this case? Because there was no disclaimer of reliance clause to point to in the asset purchase agreement. Instead, all that the defendant could point to here was a standard integration clause.
Delaware law is clear that one of the elements of any fraud-based claim is “reasonable reliance” by the claimant upon the alleged representation made by the defendant. While it may be possible in any case for a defendant to prove (after discovery and a trial) that the plaintiff could not have reasonably relied upon any alleged extra-contractual representation, a clearly drafted and properly placed non-reliance clause ensures that extra-contractual fraud claims are dead on arrival (and permit their dismissal at the pleading stage of a case without the necessity of discovery or a trial). That is so because Delaware law consistently holds that, in the face of an anti-reliance clause, a complaining party alleging an extra-contractual representation “cannot, in light of the contractual provision, have reasonably relied on the prior false statements.” Thus, in Delaware, “where parties in language that is clear provide that they will eschew reliance on any facts but those recited, they will be held to that representation, notwithstanding prior knowingly false statements made by one party to the other.” But “where the contract is ambiguous, or where it merely recites that the parties meant to integrate all their prior dealing into its terms, that contract does not preclude a party’s proof of extra-contractual fraud.”
These basic lessons in the benefits of clearly stated and properly placed anti-reliance clauses to defeat an effort by a disappointed counterparty to expand the express factual predicates to a deal, which were incorporated into a fully negotiated and signed written agreement, seem to continue to need to be relearned over and over again. And these lessons are particularly important to private equity sellers intent on prompt distribution of sales proceeds following the closing of a transaction. But the lessons from these recent cases do not end at the importance of an anti-reliance clause as distinct from a mere integration clause. Among the other lessons worth emphasizing are the following:
- While most extra-contractual fraud claims are made by buyers against sellers in the M&A context, sellers also bring such claims against buyers. That’s what happened in the Flowshare case. And, it’s not that rare. The seller was also the plaintiff in an extra-contractual fraud claim against the buyer in both the True Blue and Blackhawk Network cases.
- Extra-contractual fraud claims are not limited to claims that the defendant deliberately spoke a falsehood. Indeed, fraud claims come in a variety of shapes and sizes, not all of which require the knowing communication of a lie. Indeed, “fraud claims can be premised on reckless, not just intentional, misrepresentations; and even completely innocent misrepresentations can constitute a type of fraud (so-called ‘equitable fraud’).” And then there is so called promissory fraud—the oral communication of a promise to do something in the future that the promisor is alleged not to have ever intended to actual perform. That is the type of fraud that was alleged in the Flowshare case. And that claim survived a motion to dismiss simply because there was not a clearly stated and property placed non-reliance clause.
- Just because you have eliminated the potential dog’s breakfast of extra-contractual fraud claims from your deal by your clearly drafted and properly placed non-reliance clause does not mean that you have completely eliminated the specter of all fraud-based claims. In Delaware, fraud claims can still be premised upon the bargained-for contractual representations expressly set forth in the written acquisition agreement itself. And that option was pursued by the buyer against the seller in the ChyronHego case; and Vice Chancellor Glasscock refused to dismiss any of the fraud claims that were premised upon the written representations. But the type and nature of fraud-based claims premised upon the written representations can be severely limited by a well-crafted exclusive remedies provision. A well crafted exclusive remedies provisions seeks to limit the available remedies for all contractual misrepresentations to the specific contractual indemnification regime bargained for by the parties, including the deductibles and caps on damages. And Delaware law enforces these provisions for all types of fraud-based claims except one—knowingly conveying a falsehood in the written representations set forth in the acquisition agreement. As noted in a prior Weil Global Private Equity Insights blog post:
Delaware public policy does not permit the enforcement of a contractual provision that “purports to limit the [s]eller’s exposure for its own conscious participation in the communication of lies to the [b]uyer” in the written agreement itself. Thus, if a fraud claim is based on statements of purported fact set forth in the written agreement (rather than extra-contractual statements) and “the [s]eller knew that the [portfolio] [c]ompany’s contractual representations and warranties were false” or “the [s]eller itself lied to the [b]uyer about a contractual representation and warranty,” then the remedies available for any such purported fraud cannot be contractually limited solely to the agreed indemnification regime. In other words, contractual provisions that purport to limit fraud claims premised upon representations contained within the agreement itself, which the seller knows to be false, whether it or the portfolio company is the actual speaker, are presumptively ineffective. But, it is perfectly permissible for parties to contractually “allocate the risk of intentional lies by the [portfolio] [c]ompany’s managers to the [b]uyer,” where the seller was unaware of such lies, as well as to contractually allocate to the buyer the risk of “reckless, grossly negligent, negligent, or innocent misrepresentations of fact” by the seller or the portfolio company.
And note that this judicially created carve-out that permits fraud claims premised on written representations applies not only to the person making the representation but also to anyone who permits the representation to be made by an entity it controls, or on whose behalf he or she is acting, knowing it to be false when made. And that particular nuance was present in the claims that were made against the controlling shareholder in the ChyronHego case respecting written representations made not by the controlling shareholder but by the company being sold.
- Contractual fraud-carveouts can be much more expansive than the limited, judicially created carve-out described above regarding the conscious participation of a party in the communication of lies in the written agreement. Indeed, an undefined fraud carve-out can unintentionally expose a party to all the varieties of fraud claims respecting both extra-contractual and contractual representations made or purportedly made in the negotiation of a deal. And an inelegantly drafted carve-out can potentially expose completely innocent parties to uncapped liability simply because the claims being made are “based upon fraud” purportedly committed by someone. An effort to use a fraud carve-out to expand the available claims and reintroduce extra-contractual claims was attempted in the ChyronHego case. But in ChyronHego the fraud carve-out was specifically defined in the stock purchase agreement so as to only permit claims based upon “common law fraud.” So at least some kind of actual knowledge of the falsehood or recklessness in conveying it was required to sustain a claim for fraud premised upon the written representations. And the plaintiff’s efforts to use the fraud carve-out (which did not expressly limit itself to the written representations) in order to effectively reintroduce the extra-contractual representation claims was rebuffed by Vice Chancellor Glasscock on the same basis that Vice Chancellor Laster had done so in the Prairie Capital case; i.e., notwithstanding that the exclusive remedy provision contained a fraud carve-out that did not negate the non-reliance clause in limiting the universe of representations that a party could rely upon in asserting such claims. It is important to note both here and in Prairie Capital that the fraud carve-out was only a carve-out to the exclusive remedy provision, and not, as is sometimes seen, a carve-out to the non-reliance clause itself.
- Although not addressed in either Flowshare or ChyronHego, another Delaware Court of Chancery case suggested earlier this year that our concerns with claims of “equitable fraud” may be overblow in the M&A context. Specifically, in LVI Grp. Invs., LLC v. NCM Grp. Holdings, LLC, C.A. No. 12067-VCG, 2018 WL 1559936, at *18 n.243 (Del. Ch. March 28, 2018), Vice Chancellor Glasscock suggested that, while there was certainly caselaw supporting the proposition that a claim of equitable fraud may be pursued whenever equitable remedies are being sought, “[i]n my view, however, equitable fraud cannot be asserted simply by alleging common law fraud minus scienter and tacking on a request for restitution.” According to Vice Chancellor Glasscock a successful plaintiff in an equitable fraud action should be required to show that a special relationship exists between the plaintiff and the defendant (one that would typically not be present in the buyer and seller scenario in the M&A context). While that would be welcome news if it is universally adopted as the law of Delaware on this subject, I remain cautious. And in particular it is worth reminding everyone that not all cases are governed by Delaware law. Indeed, early this summer, the New York Court of Appeals suggested the opposite: while “constructive fraud” requires proof of a special or fiduciary relationship between the plaintiff and the defendant, in a claim for “equitable fraud “a plaintiff may bring an action for equitable rescission based on a material misrepresentation of fact that the plaintiff justifiably relied on and need not demonstrate the existence of a fiduciary duty.” More proof, it seems, of the multifarious concepts that are embodied by the broad term “fraud.”
While there are those who persist in feigning ignorance of (or actually are ignorant of) the market’s movement to define and limit fraud claims so that extra-contractual fraud is clearly eliminated by non-reliance clauses and fraud-based claims premised upon the written representations are expressly limited to carve-outs that only expose the party(ies) deliberately participating in the conveyance of knowing falsehoods concerning those written representations, don’t allow that feigned or actual ignorance to permit a counterparty to dump a dog’s breakfast of fraud claims on you after the deal closes. After all, a dog’s breakfast is not only a disgusting, muddled mess, it may interfere with the orderly distribution of sales proceeds to your limited partners and stockholders.
- ChyronHego Corp., 2018 WL 3642132, at *1.↵
- For a good example of non-reliance clause see Glenn West, Reps and Warranties Redux—A New English Case, An Old Debate Regarding a Distinction With or Without a Difference, Weil Insights, Weil’s Global Private Equity Watch, August 2, 2016.↵
- For a discussion of the proper placement of a non-reliance clause see Glenn West, The Surprising Connection Between an Extra-Contractual Fraud Claim and a Flesh-Eating Zombie, Weil Insights, Weil’s Global Private Equity Watch, March 3, 2016.↵
- TrueBlue, Inc. v. Leeds Equity Partners IV, LP, C.A. No. N14C-12-112 WCC CCLD, 2015 WL 5968726 (Del. Super. Sept. 25, 2015), discussed in Glenn West, Promissory Fraud, Anti-reliance and the Dreaded “Undefined” Fraud Carve-out, Weil Insights, Weil’s Global Private Equity Watch, October 26, 2015.↵
- Haney v. Blackhawk Network Holdings, Inc., C.A. No. 10851–VCN, 2016 WL 769595 (Del. Ch. Feb. 26, 2016), discussed in Glenn West, Private Equity Sellers Must View “Fraud Carve-outs” with a Gimlet-Eye, Weil Insights, Weil’s Global Private Equity Watch, March 16, 2016.↵
- Glenn West, A New Reason for Private Equity Sellers to Hate Undefined “Fraud Carve-outs”, Weil Insights, Weil’s Global Private Equity Watch, May 16, 2017.↵
- See Glenn West, Protecting the Private Equity Firm and its Deal Professionals from the Obligations of its Acquisition Vehicles and Portfolio Companies, Weil Insights, Weil’s Global Private Equity Watch, May 23, 2016.↵
- See generally Glenn D. West, That Pesky Little Thing Called Fraud: An Examination of Buyers’ Insistence Upon (and Sellers’ Too Ready Acceptance of) Undefined “Fraud Carve-Outs” in Acquisition Agreements, 69 Bus. Law. 1049 (2014).↵
- See EMSI Acquisition, Inc. v. Contrarian Funds, LLC, C.A. No. 12648-VCS, 2017 WL 1732369 (Del. Ch. May 3, 2017), discussed in Glenn West, A New Reason for Private Equity Sellers to Hate Undefined “Fraud Carve-outs”, Weil Insights, Weil’s Global Private Equity Watch, May 16, 2017.↵
- See ChyronHego Corp., 2018 WL 3642132, at *6; see also Prairie Capital III, L.P. v. Double E Holdings Corp, 132 A.3d 35, 55 (Del. Ch. 2015), discussed in Glenn West, Exclusive Remedy Provisions, Fraud Carve-outs, and Personal Liability for Sell-Side Private Equity Professionals, Weil Insights, Weil’s Global Private Equity Watch, December 1, 2015.↵
- People by Schneiderman v. Credit Suisse Sec. (USA) LLC, No.40, 2018 WL 2899299, at *9 n.4 (N.Y. June 12, 2018).↵