Private Equity

Two recent Delaware court decisions have highlighted the continuing risk to private equity sellers, and their deal professionals, of “the regrettably familiar situation where a buyer claims that the seller engaged in fraud related to the transaction or [fraudulently] misrepresented facts in the stock purchase agreement;”[1] claims that can be completely unmoored from the limitations on liability bargained-for in the written purchase agreement. While fraud 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,”[2] Delaware law provides clear guidance on the use of non-reliance, exclusive remedy and non-recourse clauses to curtail all but what Delaware courts have determined to be the most egregious type and source of fraud claims—deliberate and knowing intra-contractual fraud. Nevertheless, as these recent Delaware decisions demonstrate, there appears to be a continuing failure by many to fully appreciate the limitation of these clauses when it comes to deliberate and knowing intra-contractual fraud, as well as a willingness to agree to modifications of these clauses respecting extra-contractual fraud claims, the effect of which may be to completely eviscerate their benefit.

The first of these recent Delaware decisions, In re P3 Health Group Holdings, LLC, 2022 WL 15035833 (Del. Ch. October 26, 2022), involved consideration by Vice Chancellor Laster of a motion to dismiss a fraudulent inducement claim filed by an investor who had, in 2019, purchased equity units in a private equity affiliated company (the “Company”). Following its purchase of equity in the Company pursuant to a Unit Purchase Agreement (the “UPA”), the investor alleged that it had been fraudulently induced into making its investment through inflated financial projections for the year 2020, which had projected EBITDA of “north of $12.7 million,” when the actual EBITDA for 2020 turned out to be “negative $40 million.” The buyer alleged that these projections were knowingly false when made, that both the Company, its major owners, and officers of the Company and its major owners, had knowingly participated in delivering these knowingly false projections, and that the dramatic difference between the projected EBITDA and the actual EBITDA supported the inference of knowing falsity at least at the motion to dismiss stage. While there was a UPA, there is no reference in the opinion suggesting that there had been any written representation as to the 2020 EBITDA projections. In other words, this claim of fraudulent inducement appears to have been premised solely upon an extra-contractual representation, not upon any intra-contractual representations.

“Reasonable reliance” is a necessary element of any fraud claim. And the defendants first line of defense was that the UPA contained a fairly robust no representations clause that “limited the scope of the information on which [the investor] was relying,” including a specific disclaimer of any representations having been made about “projections.” All fine and good, but as discussed in other Weil blog posts,[3] undefined fraud carve-outs can wreak havoc upon your non-reliance provision.[4] And, after all the language disclaiming the existence of any extra-contractual representations in the no representations clause of the UPA, there was an undefined fraud carve-out in the final sentence, which was interpreted by Vice Chancellor Laster as making the no representations clause inapplicable to any “claims or allegations arising from or relating to fraud or intentional misrepresentation.” In other words, Vice Chancellor Laster effectively interpreted the last sentence of the no representations clause to mean there were no representations made regarding projections, except for the ones that were fraudulently made and that the investor relied upon. So, the dreaded undefined fraud carve-out added to the anti-reliance or no representations clause strikes again.

Then things got even more interesting. As noted, the investor had not only sued the Company, but also its major owners and certain officers of the Company and its major owners. And any person or entity that is alleged to have knowingly participated in the making of a fraudulent misrepresentation can be liable for that misrepresentation to the same extent as the person or entity that actually makes the misrepresentation; and the persons or entities potentially liable can include affiliates of the entity making the representation, as well as the human officers and owners of that entity or its affiliates, to the extent they knowingly cause or permit that entity to make a fraudulent misrepresentation.[5]

So, the UPA had an ineffective no representations clause that put all extra-contractual representations on the table, in addition to any deliberate and knowing intra-contractual representations (which, under ABRY Partners, is always on the table as to the maker and any other person or entity knowingly participating in the making of that representation, regardless of any clause purporting to take it off the table). But the affiliates and human agents of the Company, who were named defendants in the investor’s fraudulent inducement claim, then pointed to the no recourse clause that clearly purported to insulate all non-party affiliates and individuals from any “claims or causes of action (whether in contract, or in tort, in law or in equity) that may be based upon, arise out of or relate to this Agreement, or the negotiation, execution or performance of this Agreement (including any representation or warranty made in or in connection with this Agreement or as an inducement to enter into this Agreement).” As a matter of public policy and consistent with ABRY Partners, however, Vice Chancellor Laster ruled that the no recourse provision, no matter how clear and explicit, could not have the effect of foreclosing the investor’s suit against the various non-party affiliates and individuals that were alleged to have knowingly participated in the fraud.

This decision by Vice Chancellor Laster is consistent with a prior Delaware decision by Vice Chancellor Slights in Online Healthnow, Inc. v. CIP OCL Investments, LLC, 2021 WL 3557857 (Del Ch. Aug. 12, 2021).[6] The only difference is that in Online Healthnow, Vice Chancellor Slights was addressing a claim of deliberate and knowing intra-contractual fraud that can never be eliminated by any clause in a contract, and here Vice Chancellor Laster was addressing extra-contractual fraud that could have been eliminated by an effective anti-reliance clause but wasn’t. In other words, once you put extra-contractual fraud on the table by failing to include an effective non-reliance clause, no other provision (including a fairly robust no recourse clause) can protect non-party affiliates and individuals from liability for that extra-contractual fraud to the extent they knowingly participated in it. An anti-reliance clause is the only effective means of defeating extra-contractual fraud claims, even as to non-parties.

The second of the two recent Delaware decisions is a further endorsement of Online Healthnow’s position respecting the inability of a non-recourse clauses to eliminate intra-contractual fraud claims against non-party affiliates that knowingly participated in or facilitated the seller’s or target company’s fraudulent contractual representations. In AmeriMark Interactive, LLC v. AmeriMark Holdings, LLC, 2022 WL 16642020 (Del. Supr. Ct. November 3, 2022), the Delaware Superior Court held that “public policy considerations against fraud may defeat anti-reliance and non-recourse contractual language at the motion to dismiss stage in litigation, if the plaintiff can adequately plead that a non-signatory party was knowingly complicit when a contracting party made fraudulent misrepresentations in a contract.”

Amerimark involved a claim by a buyer against the seller, majority owner and certain officers of both the seller and the majority owner for “intra-contractual fraud,” based upon the express contractual representations set forth in an Equity Purchase Agreement (the EPA”), not “extra-contractual fraud.” Presumably the plaintiff relied solely upon the contractual representations for its fraud claim, because the anti-reliance clause was deemed effective to eliminate all claims that may otherwise be premised upon extra-contractual fraud. A typical non-reliance clause is not designed to defeat intra-contractual fraud, because contractual representations are almost always excepted from the statements as to which there was no reliance—in other words, contractual representations are almost always intended to be and are expressly stated as having been relied upon by the buyer.[7]

Here, the non-reliance clause had the typical formulation that, “except for the representations and warranties that are expressly set forth in [the EPA],” neither the Seller nor any of its Affiliates “has made, and the Buyer is not relying on, any other representation or warranty, express or implied, of the [Seller or its Affiliates] … respecting [the typical laundry list of things].” But, because the only person making the express representations in the EPA was the Seller, and the anti-reliance clause specifically disclaimed any reliance upon representations having been made by any non-party affiliates, the implication was that only the Seller could be subject to suit for intra-contractual fraud. And that was reinforced by the non-recourse clause that not only contained the traditional language exculpating non-party affiliates from any liability under or related to the contract (whether in contract, tort, in law or equity), but also added a specific statement that “no [non-party affiliates] … have made any representations or warranties, express or implied, in connection with the Transactions,” and a statement that any certificate signed by a non-party affiliate officer as part of the transaction would be “deemed to have been delivered only in such officer’s capacity as an officer of such Party (and not in his or her individual capacity) and shall not entitle any party to assert a claim against such officer in his or her individual capacity.”

All well and good, but non-party affiliates are made liable for a party’s intra-contractual fraud by their knowing participation in the making of the fraudulent representations by a party, not by making those representations themselves. And non-party affiliates can escape extra-contractual fraud claims through a broad anti-reliance clause, not through a non-recourse provision.[8] Just as an exclusive remedy provision cannot eliminate claims for the seller’s extra-contractual fraud (only a non-reliance clause can do that), or for the seller’s deliberate and knowing intra-contractual fraud (it appears that nothing can do that), a non-recourse provision cannot eliminate a non-party’s liability for its own, or its participation in the seller’s, extra-contractual fraud (only a non-reliance clause can do that), or for its knowing participation in the seller’s deliberate and knowing intra-contractual fraud (it appears that nothing can do that).[9]

Neither a non-recourse clause, nor an exclusive remedy provision, can eliminate extra-contractual fraud claims, or intra-contractual fraud claims premised upon the “conscious participation in the communication of lies” in the specific representations and warranties set forth in a written purchase.[10] But what an exclusive remedy provision can do, according to ABRY Partners, and what a non-recourse provision should also be able to do, is eliminate the seller’s, and its non-party affiliates’, liability for the seller’s “reckless, grossly negligent, negligent, or innocent misrepresentations of fact”in a purchase agreement (all of which are potential states of mind supporting tort-based claims, including, potentially, common law or equitable fraud).[11] And this is accomplished by carefully defining fraud in any fraud carve-out in both the exclusive remedy and the non-recourse clauses so that the term “Fraud” is limited to “deliberate and knowing fraud respecting the representations and warranties set forth in the agreement,” which is the only type of fraud that cannot be eliminated by a combination of the non-reliance, exclusive remedy and non-recourse clauses.

[1] Transdigm Inc. v. Alcoa Global Fasteners, Inc., 2013 WL 2326881, at *1 (Del. Ch. May 29, 2013).

[2] Glenn D. West & W. Benton Lewis, Jr., Contracting to Avoid Extra-Contractual Liability—Can Your Contractual Deal Ever Be the “Entire” Deal? 64 Bus. Law. 999, 1034 (2009).

[3] See e.g., Glenn West, Fraud Carve-Outs Come of Age, Weil’s Global Private Equity Watch, November 1, 2021, available here; Glenn West, Your Mother Was Right: Following Your Friends (or Market Studies) Off a Bridge is a Bad Idea, Weil’s Global Private Equity Watch, January 28, 2020, available here.

[4] There is a distinction between a no representations clause and a non-reliance clause. While most Delaware courts have generally been willing to give effect to most no representations clauses as having the same effect as a non-reliance clause, other courts have not—and a statement by the buyer that the seller made no other representations other than the written ones in the purchase agreement has been deemed insufficient to defeat an extra-contractual fraud claim, whereas disclaiming reliance upon any extra-contractual representations that may have been made has been deemed sufficient to defeat an extra-contractual fraud claim. Best practice is always to disclaim reliance, because reliance is an element of a fraud claim. See Glenn West, Avoiding the Other F-Word: An Anti-Reliance Clause Should Actually Disclaim Reliance on Extra-Contractual Representations Even When the Parties Agree that None Were Made, Weil’s Global Private Equity Watch, March 25, 2019, available here.

[5] See Glenn West, The Limits of Liability Limitation Provisions: Nonrecourse Clause, Like Exclusive Remedies Provision, May Be Subject to Delaware Public Policy Exception, Weil’s Global Private Equity Watch, January 25, 2021, available here.

[6] For a discussion of Online Healthnow, see Glenn West, Too Much Dynamite—The Non-Recourse and Survival Clauses Are Both Subject to Delaware’s Built-In Fraud Carve-Out for Intentional Intra-Contractual Fraud, Weil’s Global Private Equity Watch, August 24, 2021, available here.

[7] Although the court does not address it, the anti-reliance clause did contain a fraud carve-out. However, the fraud carve-out was not the undefined variety, but the defined capital F variety. Unfortunately, the court did not include the definition in its opinion, so we do not know for sure how Fraud was defined. But we can only assume that it was defined as being limited to deliberate or knowing fraud respecting the contractual representations, or the claims may not necessarily have been so limited to deliberate and knowing intra-contractual fraud. 

[8] While it is not clear that it should be necessary, making non-party affiliates express third party beneficiaries of the non-reliance, exclusive remedy and non-recourse clause is certainly preferable. And I have even suggested in the past that a specific non-reliance clause should be placed in the non-recourse clause itself. See Glenn D. West & Natalie A. Smeltzer, Protecting the Integrity of the Entity-Specific Contract: The “No Recourse Against Others” Clause—Missing or Ineffective Boilerplate?, 67 Bus. Law. 39, 69-70, 71-72 (2011). 

[9] While any clause purporting to eliminate deliberate and knowing fraud claims respecting the express representations set forth in a written agreement are subject to public policy limitations, I have previously speculated that it may be theoretically possible to curtail such claims if the agreement specifies that what purports to be representation in the written agreement actually is not a representation as to the truth of the statement made, but simply a statement of potential fact that would support contractual indemnification should it turn out to be false—i.e., the representations and warranties are solely a contractual risk allocation device. Just as all fraud claims require “reasonable reliance,” they also require there to have been an actual representation of current fact that was false. If the intra-contractual representations are not really intended to be representations of current fact at all, perhaps no fraud claim can be premised upon them. Although never tested, I suggested some possible language to attempt to accomplish this result—a true walk-a-way deal—in a 2009 article, as well as a 2016 blog post. See West & Lewis, supra note 2, at 1037; Glenn West, Reps and Warranties Redux—A New English Case, An Old Debate Regarding a Distinction With or Without a Difference, Weil’s Global Private Equity Watch, August 2, 2016, available here.

[10] Abry Partners V, L.P. v. F&W Acquisition LLC, 891 A.2d 1032, 1064 (Del. Ch. 2006).

[11] Id. at 1063.