Private Equity

Introduction

On October 16, 2018, New York’s highest court held that freedom of contract is strictly constrained by the state’s statute of limitations regime.^[1]  Parties are simply not permitted, at the time they enter into a contract, to contractually agree to delay the commencement, or extend the expiration date, of New York’s six-year statute of limitations for breach of contract.  While on its face this holding should not be that surprising, it may well have implications beyond its more obvious import.  But because this decision arose in the context of a securitization transaction, not in the M&A context, deal counsel may be tempted to ignore this decision and its potential implications for the private equity deal practice.  This decision should not be so ignored.

Survival Periods and the Statute of Limitations

When a counterparty breaches its contractual obligations, the non-breaching party is generally entitled to enforce whatever remedies are available by law against that counterparty, subject to any limitations on those remedies that may have been bargained for in the parties’ contract.  In the private equity acquisition context, those limitations on remedies typically include caps on and deductibles to (or thresholds for), and perhaps even limitations on the types of, damages that can be recovered through the indemnification regime, if any, provided for any such breach.  With respect to the representations and warranties made by a seller in a private company acquisition agreement, those limitations also specify (typically by so-called “survival periods”) the time periods, if any, during which the bargained-for remedies for any claimed breach must be pursued.^[2]

While there are sometimes survival periods that naively purport to survive indefinitely, or for some period after the expiration of the applicable statute of limitations, most knowledgeable counsel understand that the statute of limitations can be shortened by contract in most states, but rarely can it be extended.  Because inaccurate representations and warranties are typically deemed breached at the closing of a purchase and sale transaction, and the applicable statute of limitations commences upon such breach regardless of whether the buyer is then aware of the breach, there was a certain amount of consternation that arose in Delaware a few years back among buyers who had bargained for a six-year survival period for certain representations and warranties when the applicable statute of limitations was only three years.  As the result of that consternation, in 2014 the Delaware legislature actually provided contracting parties the right to extend the applicable statute of limitations for breach of contract (involving at least $100,000) from three years to as much as twenty years, without complying with the antiquated “contracts under seal” requirements.^[3]  A 2015 Delaware case suggested that a provision stating that a representation and warranty would survive “indefinitely” was sufficient to extend Delaware’s three-year statute of limitations to twenty years under that new statute even if the contract had been entered into before the adoption of that new statute.^[4]  There is no similar legislative means of extending New York’s six-year statute of limitations for breach of contract.^[5]

So what happens when a contract provides a set of written representations and warranties regarding the purchased asset(s) as of the closing date, but then limits the remedy available for the breach of such representations and warranties to a notice and cure mechanic (requiring the repurchase or replacement of transferred assets not meeting the characteristics required by the representations and warranties), rather than a suit for damages, and further contains an “accrual clause” that specifies that a cause of action for breach does not accrue until the breach is discovered, the buyer notifies the seller to cure the breach, and the seller then fails to cure?  Does such an accrual clause prevent the statute of limitations from commencing for a breach, which would otherwise occur at closing, until after the agreed-upon steps have occurred?  In other words, even if the expiration of the applicable statute of limitations cannot be extended, can its commencement be contractually delayed?  The New York Court of Appeals recently answered this question in the negative in Deutsche Bank National Trust Co. v. Flagstar Capital Markets Corp. et al., No. 96, 2018 WL 4976777 (N.Y. Oct. 16, 2018).

Contracting Parties Cannot, Pre-Accrual, Extend or Delay the Commencement of the Statute of Limitations in New York

Flagstar Capital involved the breach by the seller of certain representations and warranties contained within a purchase agreement respecting a package of residential mortgage loans that became part of a mortgage-backed securitization.  The purchase agreement contained extensive representations and warranties (made as of the closing date) as to various characteristics of the loan package, but did not guarantee that any of the loans would actually be repaid by the borrowers.  Moreover, the parties agreed that the sole and exclusive remedy for the breach of any of the representations and warranties would be to require the seller to substitute a conforming loan(s) for the nonconforming loan(s) or to repurchase the nonconforming loan(s).  The purchase agreement also contained an “accrual clause” that provided as follows:

Any cause of action against the Seller relating to or arising out of the breach of any representations and warranties made in Subsections 9.01 and 9.02 shall accrue as to any Mortgage Loan upon (i) discovery of such breach by the Purchaser or notice thereof by the Seller to the Purchaser, (ii) failure by the Seller to cure such breach, substitute a Qualified Substitute Mortgage Loan or repurchase such Mortgage Loan as specified above and (iii) demand upon the Seller by the Purchaser for compliance with this Agreement.

The Trustee for the securitized loan package, as successor to the original purchaser, did not file suit based upon a breach of the representations and warranties set forth in, or seek to enforce its sole remedy of requiring the seller to repurchase or replace any nonconforming loans as required by, the purchase agreement, until more than six years after the last closing of the loans that were included in the securitization.  The seller of the loan package therefore plead New York’s six-year statute of limitations for breach of contract claims as an absolute bar to the Trustee’s claims.  The Trustee responded that the above “accrual clause” was sufficient to create conditions precedent to the seller’s obligations respecting the representations and warranties such that the statute of limitations would not begin to run until such conditions precedent occurred (i.e., until discovery or notice and demand for cure had been made).  The Trustee further argued that the cure obligation was a promise of future performance that could not have been breached until such discovery or notice and demand for cure had been made.  Thus, in either case, the Trustee asserted that the statute of limitations could not run until six years after the breach by the seller of its obligation to cure by repurchase or substitution, not six years after the representations and warranties themselves may have been “technically” breached.  After all, because the sole remedy for such technical breach was the cure mechanic, until that mechanic had been invoked and the seller breached, there really wasn’t anything the purchaser could do to otherwise enforce those previously breached representations and warranties of which the purchaser was unaware.

A majority of the New York Court of Appeals was unpersuaded by the Trustee’s arguments, holding that the (1) the statute of limitations for breach of the representations and warranties set forth in the purchase agreement, which described the characteristics of the purchased loans as of the closing date, began to run on the closing date; (2) the accrual clause did not impose a condition precedent to the seller’s performance of the contract, but instead simply set forth the requirements for pursuing the contractually proscribed remedies for the breach of the representations and warranties that had occurred as of the closing date; and (3) New York public policy did not permit parties to contractually agree to delay commencement of, or otherwise extend, the statute of limitations before a cause of action for a breach of contract has accrued (as defined by the courts rather than the parties)—New York does permit parties to agree to toll the running of or extend the limitations period from the date a cause of action accrues for breach of a contract, but not before, as long as such tolling or extension does not exceed six years from the date of such tolling or extension agreement.^[6]

An Opposing View

There were vigorous dissents to these holdings by two of the justices.  One dissenting justice even worried about New York’s future standing “as a global center of finance and commercial transactions” as the result of the majority’s holdings.  In essence, the dissenting view was that the parties had clearly intended to delay commencement of the applicable statute of limitations through the accrual clause and freedom of contract should permit it, either because it was in fact a condition precedent to the accrual of the cause of action for breach of the representations and warranties (since the sole remedy was the cure mechanic), or because the contract actually contemplated future performance of the cure mechanic as a substantive obligation, not just a remedy for the breach of the representations and warranties that everyone agreed had actually occurred when the deal closed more than six years before suit.  After all, according to the dissenting justices, the failure of the representations and warranties to be true at closing was really not the breach, rather the failure of the seller to repurchase or replace the nonconforming loans (that were determined to not be in compliance with those representations and warranties at closing) was the actual breach of contract.  Finally, both dissenting justices appeared to analogize the representations and warranties in the purchase agreement, when coupled with the cure mechanic, as less like typical representations and warranties in the M&A arena, and more like a ten-year warranty on a watch, where the manufacturer agreed to repair or replace the watch at any time during that ten-year period if it ceased to work.^[7]  Clearly, the purchase agreement could have been worded more like a “future performance warranty” that guaranteed that the seller would repurchase or replace any loan that was determined at any time during the life of the loan to have failed to have had the stated characteristics as of the closing date, instead of using the typical representations and warranties formula, with a sole and exclusive remedy tied to a cure mechanic—and perhaps securitization lawyers will consider that change in drafting in the future.  And the majority suggested that different wording may well have won the day-note that the accrual clause actually said there had to be a “breach” of the representations and warranties before anything else followed in terms of remedies (and that “breach” uncontestably occurred on the date the loans were sold).^[8]

One of the dissenting justices suggested that parties may consider selecting Delaware rather than New York law for their future securitizations due to Delaware’s seeming clarity on the ability of parties to delay the commencement of the statute of limitations through an accrual clause.^[9]  Because the cited Delaware case stated a number of different grounds for holding that the applicable Delaware statute of limitations had not expired (including the fact that the accrual clause could itself have operated to invoke Delaware’s new extended twenty-year statute of limitations), that particular holding about the effect of the accrual clause may not be as certain as the dissent intimates.  But, then again, it might.

How Might this Holding Apply in the M&A Context?

For those of us operating in the M&A arena, rather than the securitization arena, this case raises issues about typical survival clauses and their provisos, which permit the survival period (typically employed to shorten the otherwise applicable statute of limitations) to extend until a claim is resolved (which well might be beyond the original statute of limitations that the parties agreed to shorten), as long as notice of the claim is given before the expiration of the stated period.  Is such a proviso effectively an impermissible tolling or extension of the statute of limitations?  In Delaware (with its twenty-year extension period), this question is probably irrelevant as long as the notice proviso is deemed to constitute an effective extension of the otherwise three-year statute of limitations.  And the previously noted 2015 Delaware case suggests that a typical notice extension proviso may perhaps extend the time for resolving any noticed claim to twenty years (and twenty years is a very long time).^[10]

Moreover, there is a specific Delaware case involving a survival period notice proviso and its effect in delaying the commencement of the statute of limitations.  That case, Aircraft Services International, Inc. v. TBI Overseas Holdings, Inc., C.A. No. N13C-06-265 WCC CCLD, 2014 WL 4101660 (Del Super. Ct. 2014), involved a typical acquisition agreement concerning the sale and purchase of a private company.  Based on specific language used in the acquisition agreement, the court held that the survival clause in the indemnification provision had effectively shortened Delaware’s three-year statute of limitations to just two years, but the specific wording of the proviso to the survival cause had the effect of tolling the running of that shortened statute of limitations, after notice of “a potentially indemnifiable claim,” until the claim was ultimately resolved—whenever that may be.  The survival clause in Aircraft Services contained the following proviso after stating that the applicable representation and warranty would “survive until the second anniversary of the Closing Date”:

[I]f written notice of a violation or breach of any specified representation, warranty, covenant or agreement is given to the party charged with such violation or breach during the period provided for in this Section 10.1(g), such representation, warranty, covenant or agreement shall continue to survive until such matter has been resolved by settlement, litigation (including all appeals related thereto) or otherwise.

Because notice of a breach had been given (albeit based upon a potential breach rather than an actual breach), the court rejected the seller’s argument that the proviso impermissibly extended the statute of limitation.  According to the court:

Although Delaware courts have held that parties to a contract may not circumvent the law by extending statutes of limitations, this is not what the Agreement does.  The Agreement, instead, contains a bargained-for provision that tolls the truncated statute of limitations through a notice procedure.  Contrary to Defendant’s claims, survival under the contract is not indefinite and only lasts until the precise claim is “resolved.” … Here, the contractual limitations period for the breach of representations and warranties began to run at closing.  Within the subsequent two year period, Plaintiff gave notice to Defendant that there were potential upcoming losses to be incurred due to Defendant’s alleged breach of the representations and warranties.  This worked to toll the contractual limitations period until the matter was “resolved.” Thereafter, Plaintiff had the two-year contractual limitations period in which to bring suit.

Based on Flagstar Capital, It is far from clear whether New York’s Court of Appeals would view a similar proviso in a New York law governed agreement the same way.  And when New York’s statute of limitations may be implicated (and remember that statutes of limitations are procedural, not substantive, law, so standard choice of law clauses may not choose the chosen law’s statute of limitations^[11]), it might be important to draft an acquisition agreement in terms of “indemnifiable matters” subject to indemnification, rather than “breaches” of “representations and warranties” (with attendant indemnification remedies), so as to invoke the future performance requirement of the majority opinion, at least if you are on the buy-side.^[12]

It is also important to note that the noticed claim in Aircraft Services was a “third party” claim, and certain Delaware cases have distinguished between the accrual of a direct claim for losses arising from the breach of a representation and warranty (which accrues at closing of the transaction) and a claim for payments made to third parties based upon a stand-alone indemnification obligation (which accrues as of the final settlement of such claims).^[13]  Aircraft Services appears to have conflated a breach of a representation and warranty that results in a third party claim with a stand-alone indemnity for third party claims that does not depend upon a breach of a representation and warranty in the first instance.  It is not clear whether a future Delaware case would fail to distinguish between third party claims arising from stand-alone indemnification obligations (which are independent of any breach of a representation and warranty, typically not subject to any specific survival period, and can only be breached when the indemnifying party actually fails to indemnify following the payment of such claim), and those third party claims that arise as a result of the breach of representations and warranties subject to a specified survival period (and with respect to which the indemnification provisions are a remedy, not an independent obligation).

Conclusion

Flagstar Capital is an important decision that could well have impact beyond the securitization arena, at least for agreements subject to New York law or a New York forum.  Careful drafting of survival clauses in acquisition agreements has always been important.  But now there may need to be some fresh thinking about the proper manner in which to obtain the benefit of that bargained-for survival period (and its notice proviso), without running afoul of New York’s strong public policy and legislative restrictions on pre-accrual tolling or extension of the statute of limitations.  Of course, this is only an issue for the buyer party to an agreement for which New York’s statute of limitations regime would be applicable, and who desires more than six years following the closing before commencing suit respecting an alleged breach of one or more representations and warranties.