Private Equity

Donald Sutherland may be best known as a Hollywood actor, but a man by the same name was apparently a wireless operator aboard the Parisian, a ship that navigated its way around the ice field just ahead of the ill-fated Titanic on the evening of April 14, 1912.  According to sources at the time, Mr. Sutherland claimed that he had repeatedly warned about the uncharacteristic presence of significant icebergs, which were much further south than normal.  His last transmission: “Running into ice—very thick—and big bergs.”  Mr. Sutherland, a friend of Jack Phillips, the chief wireless officer aboard the Titanic, assumed that his warning messages were passed on to the Titanic by other ships in the area, but could not confirm it.  Unfortunately, after sending that final message, he apparently shut down his wireless and retired to bed at 10PM.  Of course, as everyone knows, the Titanic, traveling at full speed, hit an iceberg approximately two hours later and Mr. Sutherland was unavailable to hear his friend’s distress calls.^[1]

The human tragedy of the Titanic’s sinking and the many questions regarding missed/ignored warnings are still the stuff of speculation today.  And there are lessons for all of us in this disaster, including for private equity deal professionals and their counsel negotiating the sale of portfolio companies.  Apparently, the Titanic received seven iceberg warnings and even passed one on itself.^[2]  Whether those warnings ever made it to the Captain and, if so, why he ignored them may never be known.  Certainly, Captain Smith’s experience had taught him that striking an iceberg was highly unlikely.  Indeed, he had made this particular crossing of the Atlantic many times before and had never struck an iceberg.  Why would this crossing be any different?

A recent post to Weil’s Private Equity blog, entitled “Avoiding a Dog’s Breakfast—Some Timely Reminders of How to Effectively Limit the Universe of Purported Representations upon which Fraud Claims Can be Made,”^[3] was the latest in a series of warnings about the risks of failing to include effective disclaimers of reliance on extra-contractual statements, and the perils of including undefined fraud crave-outs, in acquisition agreements.  These warning have sounded in various forms for over a decade now.  But alas, many are not listening to, missed, or are allowing their “experience” and deal dynamics to provide justification for ignoring, these warnings.  The fact remains, however, that a missing or ineffective disclaimer of reliance clause, or the existence of an undefined fraud carve-out, can potentially sink all of your carefully crafted contractually liability caps, even where the private equity seller and its co-investors did not knowingly participate in any fraudulent misrepresentation regarding any agreed-upon contractual representations and warranties.

And so, a recent case from Delaware Chancery Court, Great Hill Equity Partners IV v. SIG Growth Equity Fund I, C.A. No. 7906-VCG,2018 WL 6311829  (Del Ch. Dec. 3, 2018), provides yet another opportunity to issue a warning about the extreme peril that can present itself in the face of an undefined fraud carve-out floating around in your acquisition agreement.  In Great Hill Equity, the buyer claimed that the alleged fraud of the CEO of the purchased portfolio company resulted in uncapped indemnification liability for all of the selling shareholders, including an innocent private equity seller, its co-investors and two charities (who had received a gift of the portfolio company stock from the private equity seller just prior to the sale).  That seemingly ludicrous claim, that persons innocent of any fraud could be found liable for the fraud of others, was based upon—wait for it—an undefined fraud carve-out in the exclusive remedy provision of the merger agreement.

Article 10 of the merger agreement stated unequivocally that indemnification was limited to each selling shareholders’ pro rata share of an Escrow Fund, which effectively capped liability at approximately 8% of the purchase price.  But then the exclusive remedy provision stated, in relevant part:

Following the Closing, except (a) in the case of fraud or intentional misrepresentation (for which no limitations set forth herein shall be applicable) , …, the sole and exclusive remedies of the parties hereto for monetary damages arising out of, relating to or resulting from any claim for breach of any covenant, agreement, representation or warranty set forth in this Agreement, the Disclosure Schedule, or any certificate delivered by a party with respect hereto will be limited to those contained in this Article 10.

And, predictably, the buyer made numerous claims of fraud, based on both the contractual representations and certain purported extra-contractual statements and omissions.^[4]  Only one of these numerous claims stuck, a claim that the portfolio company’s CEO, a significant selling shareholder, knowingly misrepresented (by causing the company to make a contractual representation in the merger agreement that he allegedly knew to be false) that no “supplier of products or services to the Company … had notified the Company … that it intends to terminate its business relationship with the Company ….”  But based upon a finding of fraud against one individual selling shareholder, the buyer argued that, as a result of the undefined fraud carve-out to the exclusive remedy provision, its claims for indemnification based upon the breach of that express representation and warranty in the acquisition agreement should not be limited to the Escrow Fund, “and that liability should attach to all [selling shareholders] regardless of their participation in or knowledge of the alleged fraud.”

Of course, this is not the first time such an allegation has been made, and a previous warning about the risk of such an allegation being made was issued in a 2017 post to Weil’s Private Equity blog, entitled “A New Reason for Private Equity Sellers to Hate Undefined ‘Fraud Carve-outs.’”^[5]  In the case discussed in that post, EMSI Acquisition, Inc. v. Contrarian Funds, LLC, C.A. No 12648-VCS, 2017 WL 1732369 (Del. Ch. May 3, 2017), Vice Chancellor Slights held that an undefined fraud carve-out could in fact be construed as allowing an indemnification claim against all selling shareholders, including those ignorant of the alleged fraud, based upon the fraud of the management of the portfolio company being sold.  He also allowed that it could also mean that the selling shareholders had simply excepted, from the contractual indemnification caps, tort claims against the individuals involved in the fraudulent activity.  Because there was thus two reasonable interpretations to the undefined fraud carve-out, Vice Chancellor Slights declared the clause ambiguous, the result of “inelegant drafting,” and stated that “[t]he Court will require extrinsic evidence to construe the ambiguous indemnification provisions within Article X before determining which of the competing interpretations reflects the parties intent with respect to indemnification for claims of fraud against the [selling shareholders] arising from misrepresentations by the Company” through the managements’ knowing participation (without corresponding knowledge by the other selling shareholders) in making the contractual misrepresentations on behalf of the Company.  Of course, the case was thereafter settled so that extrinsic evidence was never introduced.

Contrary to Vice Chancellor Slight’s decision in EMSI, Vice Chancellor Glasscock determined that extrinsic evidence of intent was not required because the clause at issue in Great Hill Equity was unambiguous on its face—the carve-out did not permit unlimited indemnification claims against all selling shareholders if there was a fraudulent misrepresentation made by one selling shareholder; rather the carve-out only allowed tort claims (not indemnification claims) based upon an alleged fraudulent misrepresentation, and such claims could only be pursued  against the actual fraudsters.  But the undefined fraud carve-out at issue in EMSI was worded somewhat differently than the undefined fraud carve-out in Great Hill Equity; its language suggested a little stronger link between the uncapping of liability generally on the indemnification remedy when any fraud was present than did the language at issue in Great Hill Equity.  The fraud carve-out in the acquisition agreement at issue in EMSI stated that “nothing in this Agreement (or elsewhere) shall limit or restrict … any Indemnified Party’s rights or ability to maintain or recover any amounts in connection with any action or claim based upon fraud.” Regardless, undefined fraud carve-outs are fraught with potential ambiguity.  In  an earlier decision on a motion to dismiss in the Great Hill Equity case, Vice Chancellor Glasscock hinted at the potential ambiguity of the fraud carve-out that he ultimately determined was unambiguous, noting that its meaning “would be helpfully illuminated by evidence of the parties’ intent.”

While Vice Chancellor Glasscock’s ultimate ruling is a welcome relief to private equity sellers who have agreed to amorphous, undefined fraud carve-outs (at least this particular version of such clauses), and it is certainly consistent with this author’s view of what people actually mean when they insert such provisions in the agreement, it does not change the fact that this case has been in litigation since 2012, and there is still more to come.  Being rescued when you hit an iceberg is certainly preferable to the alternative, but avoiding hitting the iceberg in the first instance is always better.

It is important to note that the issue of whose fraud matters, in uncapping the liability-limitation regime, is literally just the tip of the iceberg of perils that undefined fraud carve-outs pose.  The number of other, just under-the-surface, hazards that can do serious damage to your carefully crafted and capped liability-limitation regime are legion.  They include issues as to what kind of fraud is actually being carved out (yes there are surprising forms of fraud that do not involve the deliberate conveyance of falsehoods), as well as whether the fraud carve-out encompasses fraud with respect to any statement made in the course of negotiation, or only with respect to those statements that the parties agreed were the bargained-for factual predicates for the deal and therefore important enough to incorporate into the written acquisition agreement.^[6]  And it is now established market practice, wherever possible, to define fraud carve-outs so that only intentional misrepresentation by a particular selling party respecting the specific representations and warranties forth in the agreement is actually carved out from the liability caps.^[7]

The next time you are faced with a request for an undefined fraud carve-out to your carefully-crafted, liability-limitation regime, recall this warning and proceed accordingly: “Running into ice—very thick—and big bergs.”