Private Equity

In Delaware, a robust and properly placed disclaimer of reliance clause can effectively eliminate claims of fraudulent or negligent misrepresentation arising from extra-contractual statements made by or on behalf of a seller during the negotiation of a written acquisition agreement. And an effective exclusive remedy clause can limit the remedies available for any inaccuracy in the package of contractual representations and warranties that were expressly bargained for in that written acquisition agreement, as long as the persons making or causing those written representations and warranties to be made did not actually know that those written representations and warranties were false when made—i.e., in Delaware, a fraud claim based upon written representations and warranties can always be made upon allegations that the makers (or persons controlling or participating with the makers) deliberately conveyed a knowing falsehood through those written representations and warranties, even in the absence of a negotiated fraud carve-out.^[1] Two recent Delaware cases provide useful illustrations of how these concepts work in post-closing disputes arising from alleged fraud in connection with the sale of a portfolio company business by a private equity fund.

In Infomedia Group, Inc. v. Orange Health Solutions, Inc., C.A. No. N19C-10-212 AML CCLD, 2020 WL 4384087 (Del Sup. Ct. July 31, 2020), a portfolio company of a private equity fund sold a business line through an asset purchase agreement. In the asset purchase agreement, the seller specifically represented and warranted that no counterparty to any of the contracts being transferred to the buyer had given “any written notice of any . . . intention to terminate, amend, or modify (including any material change in anticipated call volume) any Contract.” Apparently it was true that no contract counterparty had provided any “written notice” to the seller of any intention to terminate, amend or modify any of the transferred contracts as of the date the acquisition agreement was both signed and closed. But according to the buyer, the seller (and its private equity fund owner) had “orally represented to [the buyer] on ‘numerous occasions [before] the execution of any agreement that [the seller and its private equity fund owner] were not aware of any customer that intended to terminate any of the Contracts.’” The buyer alleged that a few weeks before the asset purchase agreement was signed and closed one of the top customers of the business line being purchased had in fact orally communicated to the seller its intention to terminate a number of the contracts that were being transferred to the buyer. And the buyer also alleged that the private equity fund owner had been advised of this communication, but neither the seller nor the private equity fund owner made the buyer aware of that oral communication. So, when the buyer later learned of the customer’s intent to terminate its contracts, the buyer sued the seller and its private equity fund owner for fraud and negligent misrepresentation.

The seller and its private equity fund owner moved to dismiss the claim based on the express disclaimer of reliance clause whereby the buyer had agreed that, other than the written representations and warranties specifically set forth in the asset purchase agreement, it was not relying on any other representations or warranties made by the seller or any other person.^[2] And the court, reviewing the consistent and overwhelming body of Delaware precedent, granted that motion in favor of the seller and its private equity fund owner. The buyer also argued, however, that the written representation regarding the fact that the seller had not received any written notice of any intention to terminate any of the contracts was itself fraudulent even though “facially true” because it created a “false impression as to the true state of affairs.” But the court rejected this argument because “[t]he fact that oral notice might have been received does not make the representation about written notice misleading.”^[3] Instead, through the anti-reliance clause, the parties had bargained for the express written representations to “define the universe of information that is in play for the purposes of a fraud claim.”^[4] Thus, because the written representation was expressly limited to the absence of “written notice,” and none had in fact been received, the suit was dismissed.

But even when fraud claims premised upon extra-contractual representations have been precluded by a non-reliance clause, the express written representations can sometimes provide a basis for a claim of fraud, at least at the motion to dismiss stage. In Agspring Holdco, LLC v. NGP X US Holdings, L.P., C.A. No. 2019-0567-AGB, 2020 WL 4355555 (Del Ch. July 30, 2020), a private equity fund sold all of its membership interests in a portfolio company formed as a limited liability company to another private equity fund buyer pursuant to a Membership Interest Purchase and Contribution Agreement (the “MIPCA”). As is not uncommon, the management team for the purchased business also owned membership interests in the company and agreed to join in the MIPCA, sell part (and roll over the remainder) of their membership interests, and continue to serve on the management team (and as members of the board) of the acquired company post closing. 

The management team consisted of two individuals who had originally been the founders of the company and served as its President and Chief Executive Officer. During the negotiations of the MIPCA, the management team provided internal financial models to the buyer that projected EBITDA for next fiscal year following the acquisition. According to the buyer, those projections were reduced twice before the MIPCA was signed and, in each case, the reduction was disclosed to the buyer and an agreed reduction in the purchase price was negotiated. But when those internal projections were allegedly revised a third time, neither the management team nor the private equity fund owner disclosed those internal forecast changes to the buyer. The third undisclosed revision to the internal forecasts allegedly reflected a 39% reduction in projected EBITDA for the next fiscal year (from $33 million to $20 million). Alas, the actual EBITDA ended up being less than $1 million and the buyer sued the management team and the private equity fund seller for fraud.

The MIPCA apparently contained a non-reliance clause, an indemnification regime with a cap and deductible, an exclusive remedy provision limiting the buyer’s remedies to the capped indemnification out of an agreed escrow amount (with an undefined fraud carve-out)^[5] and a survival period that expired well before the buyer commenced suit on its claims against the private equity fund and the management team. Presumably, the non-reliance clause dissuaded the buyer from bringing any fraud claims premised upon extra-contractual representations. Thus, the buyer’s claims were all premised upon the written representations and allegations that those representations were knowingly fraudulent when made.^[6]

Fraud claims based on missed projections are typically not sustainable in Delaware because “[p]redictions about the future cannot give rise to actionable common law fraud.”^[7] Indeed, earnings forecasts “are simply statements of expectation or opinion about the future of the company and the hoped for results of business strategies [, and] [s]uch opinions and predictions are generally not actionable under Delaware law.”^[8] But, there were two written representations in the MIPCA that provided a hook to allow the buyer’s claims regarding the alleged undisclosed revision to internal forecasts to survive the sellers’ motion to dismiss.^[9]

The first written representation that provided a hook to the alleged fact that there had been a significant, undisclosed reduction in the internally forecasted EBITDA was an unusually broad representation regarding “material contracts.” Specifically, the company represented in Section 4.5(c) of the MIPCA that, to its knowledge, “no event has occurred or circumstance exists that . . . may . . . result in a material violation or material breach of, or give any . . . other Person the right to declare a default or exercise any remedy under, or to accelerate the maturity or performance of, or to cancel, terminate or modify, any Material Contract.” The company was party to a $22 million note that required annual interest payments of $1.2 million (the “Tubbs Note”). The court had no trouble concluding that the Tubbs Note was a “Material Contract.” For the purposes of the motion to dismiss, the court further concluded that “it is reasonably conceivable that, contrary to the representation made in Section 4.5(c), events had occurred that would make it unmanageable for the Company to service its debt and result in a material breach of the Tubbs Note.” In other words, whatever events had led the company to internally revise its forecasted EBITDA downward by 39% could well have been events that “may” later result in the company defaulting on the Tubbs Note. Thus, the alleged fraud was not misrepresenting its projected EBITDA, but misrepresenting that no events had occurred as of the closing that “may” impact the repayment of the Tubbs Note (a Material Contract). And the events that occurred were allegedly the poor year-to-date results that had apparently caused the company to revise its internal projections.

The second written representation that the court found to be sufficient to deny the sellers’ motion to dismiss was in Section 4.15(m) of the MIPCA. That representation stated that “there has not been any . . . Material Adverse Effect” at the company since May 31, 2015. “Material Adverse Effect” was traditionally defined as “any change, circumstance, effect, event, occurrence or condition that, individually or in the aggregate, has had or would reasonably be expected to have a material adverse effect on [the company or its business], taken as a whole.” And of course that definition was subject to a number of exceptions, including the common exception that carves out from the definition of Material Adverse Effect “any failure or inability . . . to meet any projections, forecasts or estimates of revenue of earnings.” But as is often the case, that exception was itself subject to a carve-out—i.e., “except to the extent that . . . the facts or circumstances giving rise to such failure or inability may themselves be deemed to constitute, or to be taken into account in determining whether there has been a Material Adverse Effect.” Thus, similar to the court’s holding with respect to the potential breach of Section 4.5(c), the court held that, “[d]rawing all reasonable inference in Plaintiffs’ favor at this stage of the case [a motion to dismiss], the Complaint sufficiently pleads facts concerning the circumstances that gave rise to the Company’s failure to meet its forecast to support a reasonably conceivable claim that the representation in Section 4.15(m) was false when made.”^[10]

For the private equity community, it is significant that in each of these cases the private equity fund owner itself was sued for fraud. In Infomedia Group, the private equity fund owner’s involvement in the suit was short-lived because of the existence of a well-crafted non-reliance clause and the inability of the court to find a reasonably conceivable basis upon which the sellers’ written representation could have been fraudulent when made. But in Agspring Holdco, the court did find a reasonably conceivable basis for concluding that the written representations were fraudulent. And then the question became how to attribute knowledge of the fraudulent nature of those written representations to the private equity fund owner. To do so, the buyer alleged the following: (i) the private equity fund owner owned 98% of the company and controlled 3 out of 5 seats on the board; (ii) the private equity fund owner had a financial advisory agreement with the company whereby it had contractually agreed to “provide advice and consultation to [the company],” including “providing general oversight of legal and accounting issues; implementing a long term budgeting and planning process; mergers and acquisitions; and strategies and financing alternatives;” (iii) the private equity fund owner had been actively involved in the sales process, had given specific feedback in the preparation of EBITDA calculations, and was obviously motivated to make the company “look more attractive to potential investors;” (iv) the board (on which the private equity fund owner’s appointees sat), was made aware of the company’s “declining volume and margins;” and (v) there were emails suggesting that the private equity fund owner had pushed “to close the deal as the Company’s forecasts worsened.” Thus, “[the private equity fund owner] was in a position to know . . . the knowable reality underlying the alleged falsity of the representations in Sections 4.5(c) and 4.15(m) that was concealed from [the buyer], i.e., that [the company’s] financial results had declined dramatically over the prior six months necessitating material reductions to its forecast for the 2016 fiscal year, which severely threatened [the company’s] earnings and imperiled its ability to service its debt after closing.” But in essence, what the buyer alleged was that the management team and the private equity fund owner worked together in deceiving the buyer and lenders into “enter[ing] into the MIPCA and related agreements by providing them with an artificially inflated financial model containing a forecast that was millions of dollars higher than [the company’s] actual internal model to justify a price that [the private equity fund owner] was demanding in the Transaction, i.e., one that would provide the [the private equity fund owner] a two times return on its initial investment of $150 million.”

It is important to note that the allegations against the private equity seller in Agspring Holdco are just that, allegations; the buyer must now prove these allegations at trial. But the private equity seller who contractually capped its post closing exposure to an indemnification escrow for an agreed survival period must now defend these allegations at a full trial involving significant expense and time with a risk of uncapped liability. And obviously there is incentive to settle these claims now, even if the private equity fund seller believes it is completely innocent of any actual knowledge of the alleged fraud. As has been previously noted:

[C]laims of fraud can be “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.” And the fact that these claims can emerge after distributions of the sales proceeds have been made to the limited partners, and that they can result in personal liability to the deal professionals participating in the negotiation of the purchase and sale agreement, should cause all private equity sell-side participants to take measures to mitigate these risks, even if they believe no one in their organization would ever knowingly engage in any conduct that would be considered fraudulent.^[11]

For the sell-side private equity fund owner, it is not enough to insist that the buyer disclaim reliance upon extra-contractual statements that are not part of the bargained-for package of written representations and warranties, nor is it enough to insist that the capped indemnification regime, with a limited survival period, is the exclusive remedy for a breach of those written representations and warranties. In addition to creating a record of full disclosure and encouraging the management team to do the same, sell-side private equity fund owners must also carefully negotiate and limit the actual written representations and warranties that are part of the contractual package subject to that exclusive indemnification regime so that to the extent possible, those representations and warranties do not themselves become the basis of a fraud claim. Whenever possible, written representations and warranties should address verifiable current facts only; and when there is a requested representation that is not verifiable, but is nonetheless requested as a risk allocation subject to the indemnification regime, consider inserting a clause that says just that and disclaiming that the representation is intended to be an assertion of known truth.^[12]