Private Equity

In a recent Delaware Court of Chancery decision, Online Healthnow, Inc. v. CIP OCL Investments, LLC, 2021 WL 3557857 (Del Ch. Aug. 12, 2021), Vice Chancellor Slights analogized the attempted use of certain contractual limitation of remedies provisions to “dynamite,” and suggested that the sellers had, much like Butch had in the final train robbery scene in Butch Cassidy and the Sundance Kid, used a little “too much” in their Stock Purchase Agreement (SPA). Indeed, the literal effect of the SPA’s “remarkably robust survival, anti-reliance and non-recourse provisions [was] to atomize [the buyer’s] claims across all of the recognized planes of contractual limitations.” The legal effect of these “remarkably robust provisions,” however, was subject to the public policy limitations of ABRY Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006) and its progeny.

Delaware law permits sophisticated parties to contractually limit the universe of information that the buyer has relied upon as the “factual predicate” for the buyer’s decision to enter into an acquisition agreement. Parties can do so through a non-reliance clause that effectively disclaims the buyer’s reliance upon any representations purportedly made by the seller or its representatives other than those expressly set forth in the finally negotiated and executed acquisition agreement. If worded appropriately and made by the buyer itself, such clauses can effectively eliminate any claim for fraud that is premised upon any extra-contractual statements made during the negotiation of the acquisition agreement, even if those statements constitute outright lies, because without reliance there can be no fraud. And Delaware has not imposed any public policy limitations on the effectiveness of anti-reliance provisions, even if they “atomize” all extra-contractual fraud claims.

But fraud claims in Delaware can be premised not only upon extra-contractual representations (in the absence an effective non-reliance clause), but also upon contractual representations and warranties set forth in the acquisition agreement itself (so-called “intra-contractual fraud,” which the non-reliance clause does not address). And the fraud claimed by the buyer in Online Healthnow was intra-contractual fraud based upon alleged fraudulent misrepresentations made within the acquisition agreement itself.

Anyone with even a passing familiarity with the seminal Delaware decision of ABRY Partners and its progeny, know there are limits to the extent to which an exclusive remedy provision can actually work to exclude remedies in the face of certain types of intra-contractual fraud claims. In ABRY Partners, then Vice-Chancellor Strine famously created a built-in public policy fraud carve-out to all exclusive remedy provisions that carved out any fraud claim based upon a representation specifically set forth in the written agreement being alleged to have been knowingly false when made. But note that this built-in fraud carve-out does not include all types of fraud that could be alleged based upon the written representations and warranties set forth in the agreement; instead it only carves out those intra-contractual fraud claims involving an illicit state of mind—i.e., those fraud claims based upon the written representations and warranties where the buyer can “prove that the [s]eller knew that the [contractual] representation was false and either communicated it to the [b]uyer directly itself or knew that the [c]ompany had.”

Thus, selling stockholders who know that the company has made a false representation in a stock purchase agreement have exposure to this built-in fraud carve-out, even when they have not made any of the representations in the contract themselves, and even though they are not parties to any closing certificate.^[1] As noted in another recent Delaware decision explicating the impact of ABRY Partners and its progeny, “if a seller ‘knew that the company’s contractual representations were false,’ the seller cannot ‘insulate’ itself from contractual fraud by hiding behind the company’s representations.”^[2] And because knowledge of falsity requires a conscious human mind, the actual human agents of the sellers who have this knowledge have direct personal liability for this type of fraud liability in addition to any entity seller for whom they have acted.^[3]

Delaware’s built-in fraud carve-out, then, is limited to claims based upon the conscious communication of “lies” by a seller through the written representations and warranties made by the seller, or made by the company with the seller’s knowledge, in the agreement. Liability for any claim of contractual fraud based on any lesser state of mind can be effectively eliminated by the exclusive remedy provision and other related clauses. Even if the company’s managers deliberately falsified information and knew that the representations in the agreement were false, Delaware’s built-in fraud carve-out does not expose the sellers, who had no knowledge of such fraud, to liability beyond the negotiated indemnity caps, if any. Similarly, even when the sellers themselves “acted in a reckless, grossly negligent, or negligent manner” in agreeing to make or allow the company to make false representations in the agreement (all of which states of mind can create potential common law or equitable fraud claims), Delaware’s built-in fraud carve-out does not carve out such claims and will not permit the buyer to avoid “its own voluntarily-accepted limits on its remedies against the [s]eller absent proof that the [s]eller itself acted in a consciously improper manner.”^[4]

In Online Healthnow, the non-recourse clause and the survival clause both operated similar to an exclusive remedy provision in purporting to eliminate potential claims that were otherwise reachable by Delaware’s built-in intra-contractual fraud carve-out. Thus, Vice Chancellor Slights rejected the seller’s, and its private equity owner’s, attempt to rely upon (a) the survival clause, which specified that all contractual representations and warranties terminated at closing, to attempt to defeat an intentional intra-contractual fraud claim based upon those representations and warranties post-closing; and (b) the non-recourse clause, which purported to insulate from liability non-party affiliates, to attempt to defeat intra-contractual fraud claims against the private equity owner of the seller who was alleged to have “know[n] of and facilitate[d] the fraudulent misrepresentations in the SPA.” The clauses themselves were not “too much dynamite;” instead it was their attempted use to defeat claims premised upon the only type of fraud for which Delaware law provides a built-in fraud carve-out—i.e., intentional intra-contractual fraud (or the communication of knowing misrepresentations in the express representations and warranties contained in the acquisition agreement).

Given the existence of Delaware’s built-in intra-contractual fraud carve-out, it would have been sleeves off the seller’s vest to offer and include a contractual fraud carve-out to the non-recourse and survival clause that matched the built-in one. But remember to be careful on the sell-side that your contractual fraud carve-outs match, rather than expand, the built-in fraud carve-out for intentional intra-contractual fraud. Otherwise you may not be offering only the sleeves off your vest, but part of the vest itself.^[5]