Private Equity

By now we should all be well-schooled in the various types and sources of fraud claims, as well as the dangers of undefined fraud carve-outs to the sell-side in an M&A transaction governed by Delaware law. But a recent decision by the Delaware Supreme Court, Express Scripts, Inc. v. Bracket Holdings Corp., 2021 WL 752744 (Del. Feb. 23, 2021), provides an opportunity to reaffirm that prior schooling and ensure, for the sell-side, that fraud carve-outs only encompass deliberate lying by the seller itself respecting the negotiated contractual representations set forth in the written acquisition agreement.

To appreciate Express Scripts’ holding, however, let’s first recap our basic schooling in Delaware law concerning claims of fraud in the face of an exclusive remedy provision:

• Allegations of fraud can wreak havoc with the carefully negotiated limitation of remedies in a limited indemnity or no indemnity deal, even if they ultimately are just unproven allegations. Fraud allegations are difficult to dismiss without a trial and can therefore be expensive to deal with, and are subject to the potentially erroneous conclusions of judges and juries. Moreover, unlike contract-based claims, which are generally limited to the entity parties to the acquisition agreement, tort-based fraud and misrepresentation claims expose individual officers and other representatives of the entity parties to liability for such alleged torts.
• A non-existent, improperly placed, or inappropriately worded no reliance clause can expose sellers to “a dog’s breakfast” of extra-contractual fraud claims based on alleged statements made by the target’s management or the seller’s representatives during the diligence or negotiation process. And those statements, if made at all, may have been made with far less deliberation than would typically be involved in the consideration of the negotiated representations and warranties set forth in the written acquisition agreement. An exclusive remedy provision alone does not eliminate these tort-based, extra-contractual fraud claims. A properly placed and robustly worded no reliance clause, however, can effectively eliminate the specter of any fraud claim premised upon statements made outside of the specifically negotiated written representations and warranties set forth in the acquisition agreement. In the absence of reasonable reliance (which a properly worded no reliance clause contractually negates), a fraud claim is simply unsustainable.
• While the dog’s breakfast of extra-contractual fraud claims can be eliminated through a no reliance clause in Delaware, fraud claims can also be premised upon the contractual representations and warranties set forth in the written acquisition agreement. And the no reliance clause simply has no impact on such claims, principally because acquisition agreements normally state that the negotiated written representations and warranties were in fact relied upon and because the no reliance clause typically excepts those contractual representations and warranties from the scope of non-reliance.
• Although fraud claims premised upon the contractual representations and warranties cannot be completely eliminated in Delaware, based on Abry Partners and its progeny an exclusive remedy provision can effectively eliminate any such claims of fraud except for “the [s]eller’s exposure for its own conscious participation in the communication of lies to the [b]uyer” respecting those written representations and warranties. Thus, as a result of a built-in public policy fraud carve-out to every Delaware acquisition agreement, an exclusive remedy provision (no matter how broadly worded) does not limit the remedies available to a buyer respecting the written representations and warranties when “the [s]eller knew that the [target] [c]ompany’s contractual representations and warranties were false” or where “the [s]eller itself lied to the [b]uyer about a contractual representation and warranty.” Nevertheless, an exclusive remedy provision can completely eliminate fraud or other tort-based claims respecting the written representations and warranties set forth in an acquisition agreement that are premised upon “reckless, grossly negligent, negligent, or innocent misrepresentations of fact” by the seller, as well as “intentional lies by the [target] [c]ompany’s managers to the [b]uyer” (as long as the seller is unaware of such lies by the target company managers).
• But an undefined or poorly defined contractual fraud carve-out can significantly expand this limited Delaware public policy fraud carve-out and thereby expose selling parties and their representatives to potential claims for fraud based upon much less egregious mental states than deliberate lying, expose innocent selling parties to the fraud of culpable selling parties or their representatives and potentially reintroduce the specter of extra-contractual claims by creating a conflict between the no reliance clause and the fraud carve-out to the exclusive remedy provision.
• From the sell-side perspective, a well-crafted fraud carve-out to an exclusive remedy provision defines fraud so that the term only encompasses what Delaware public policy’s so-called “Abry framework” demands: imposition of tort-based liability, notwithstanding contractual limits, on the seller or its representatives for deliberate lying by such seller or its representatives respecting the contractual representations and warranties.^[1]

With this background in mind, the Delaware Supreme Court’s holding in Express Scripts is somewhat mundane: An exclusive remedy provision’s fraud carve-out that used the word “deliberate” in front of the otherwise undefined term “fraud” effectively defined fraud as only encompassing the intentional variety of fraud, which made the Superior Court’s instruction to the jury erroneous because it included recklessness as being a sufficient state of mind to constitute fraud. But there are, nonetheless, important lessons that can be gleaned from this case.

According to the Delaware Supreme Court: “A deliberate state of mind is a different kettle of fish than a reckless one.” In contrast to that clear holding of the Delaware Supreme Court, the Delaware Superior Court had held that:

The Court does not believe that the inclusion of one undefined term – “deliberate” – in the indemnification section of the SPA alters the mental state required for common law fraud. This can only be done by express agreement and the Court will not imply such an agreement into the SPA. As there is no clear articulation of the parties’ intent to alter the mental state required by law, the Court properly instructed the jury to consider recklessness.^[2]

The Superior Court’s decision was aided by some unfortunate inconsistency and overuse of fraud carve-outs throughout the SPA, as well as the misspelling of the word “deliberate,” and its grammatically challenging placement in the fraud carve-out to the exclusive remedy provision.

But the Delaware Supreme Court strongly disagreed with the holding of the Superior Court—the use of the descriptive adjective “deliberate” to modify the type of fraud that was being carved out from the exclusive remedy provision was the equivalent of “intentional fraud” and did indeed exclude recklessness as a mental state that would have otherwise be sufficient to constitute common law fraud:

A deliberate state of mind does not equate to a reckless state of mind. The parties used “deliberate” to describe a specific state of mind. [The buyer] agreed that, absent deliberate fraud, its sole and exclusive remedy for breach of the representations and warranties was the R & W Policy. The Superior Court erred when it instructed the jury that it could find for [the buyer] if it proved that the defendants acted with a reckless state of mind.

And the other undefined fraud carve-outs used elsewhere in the SPA were effectively trumped by the one in the exclusive remedy provision that used the modifier “deliberate.”^[3]

Common law fraud has always allowed claims to be premised not only upon a misrepresentation that was made by a person who knew it to be false, but also upon a misrepresentation that, even if believed to be true, was not known to be true by the person who made it.^[4] How many times is the sell-side requested to include contractual representations and warranties in a SPA that are not knowledge qualified, which the sell-side believes to be true, but cannot know for certain are in fact true? And how many times, as a matter of contractual risk allocation, is the sell-side persuaded to make those flat reps? By making those flat reps, as a matter of contractual risk allocation subject to a carefully negotiated liability limitation regime, is the sell-side risking being accused of recklessness for the purpose of a tort-based fraud claim based upon those contractual reps? 

While the case law is squishy on what it means to be reckless when it comes to claims of fraud, suffice it to say that it’s a much different and lower standard of culpability than that encompassed by someone making a statement that he or she knows to be false. And letting a jury consider this lower, squishy state of mind, as did the Superior Court in Express Scripts, would certainly increase the odds of an erroneous conclusion being made that actual fraud occurred. But here, after several years of litigation, the Delaware Supreme Court declared that recklessness is not the same as deliberateness or intentionality, and inserting that one word modifier, “deliberate,” in the fraud carve-out to the exclusive remedy provision was enough to make that clear. So here is another warning^[5] for the sell-side to use appropriate modifiers in your fraud carve-outs.