Private Equity

Almost everyone can remember a time when you asked permission to do something that your mother thought was ill-advised, dangerous or just plain stupid.  And when your mother said “no” and you protested that all your friends were doing it, your mother would ask the inevitable question:  “Well, if your friends jumped off a bridge would you do it?”  While there is a precocious few that might have answered “it depends on the reason they were jumping, or how high the bridge was … maybe they know something I don’t about the bridge,”^[1] most of us simply said “no” and that was the end of the discussion.  In today’s private equity deal dynamics, the friends deal professionals and their counsel are being encouraged to follow off a bridge can sometimes be the numerous deal point studies that have proliferated in the market place since the ABA first published its pre-eminent Private Target Deal Points Study in 2006.  While all these deal point studies have their benefits, their major drawback is that they only examine a limited data set that is available either publicly or proprietarily to the study’s provider,^[2] and they tend to group various deal points in a manner that does not reflect important nuances in language that can dramatically impact the effectiveness of certain provisions.  Another more fundamental drawback is that even when the limited data set that forms the basis for a particular study accurately reflects what is actually happening in the market place, the market (like your friends) may be doing things that are ill-advised, dangerous or just plain stupid.

A particular case in point are non-reliance/no other representations clauses and related fraud carve-outs.  According to the 2019 ABA Private Deal Point Study, approximately 63% of the deals included in the data set include some form of non-reliance provision, although the authors of the study suggest that, based on Delaware caselaw declining to require “magic words,” this 63% includes clauses that may not specifically include a variant of the word “rely.”  Thus it is not clear how effective all of these various clauses are in accomplishing the objective of a non-reliance clause, which is to eliminate any claims of fraud based upon purported statements of fact made outside of the express representations and warranties bargained for in the written acquisition agreement.^[3]  According to Delaware law, as recently reiterated in Kainos Evolve, Inc. v. In Touch Technologies, Inc., C.A. No. 2018-0712-AGB, 2019 WL 7373796 (Del. Ch. Dec. 31, 2019):

As explained in Abry, the Court will not bar a contracting party from asserting claims for fraud based on representations outside the four corners of the agreement unless that contracting party unambiguously disclaims reliance on such statements. The language to disclaim such reliance may vary, as the Court noted in Prairie Capital, but the disclaimer must come from the point of view of the aggrieved party (or all parties to the contract) to ensure the preclusion of fraud claims for extra-contractual statements under Abry and its progeny.^[4]

While a statement by the buyer that the seller has not made any other representations beyond those set forth in the written agreement may theoretically be sufficient, in Delaware, to disclaim reliance upon extra-contractual statements that are nonetheless alleged to have been made by the seller, that is not true in all states.^[5]  Moreover,  in Delaware a simple “assertion by the seller ‘of what it was and was not representing and warranting’ is not sufficient” to eliminate claims of fraud based upon extra-contractual statements of fact that the buyer claims it did in fact rely upon.^[6]  Thus, in Kainos Evolve, Chancellor Bouchard refused to dismiss fraud claims brought by InTouch against Kainos Evolve based upon purported extra-contractual representations allegedly made by Kainos Evolve where the contract only contained a standard integration clause and a “no representations” clause that provided: “[Kainos] makes no warranties of any kind, whether express, implied, statutory or otherwise, and specifically disclaims all implied warranties.”  According to Chancellor Bouchard, “the cited provisions of the Agreement, considered collectively, do not contain language that amounts to an unambiguous disclaimer of reliance on statements outside the Agreement’s four comers that comes from the point of view of the “aggrieved party,” i.e., the party asserting the fraud claim—InTouch.”^[7]

But even if all of the clauses comprising the 63% containing some form of non-reliance clause are effective, that still means there are a significant number of acquisition agreements that do not contain any purported non-reliance clause of any kind.  More disturbing still, the 2019 ABA Private Deal Point Study also reveals that a substantial majority of the non-reliance clauses making up that 63% include express fraud carve-outs.  And the study does not reveal whether these fraud carve-outs are of the undefined or the defined variety.  If the express purpose of the non-reliance clause is to eliminate all fraud-based claims that could otherwise be premised upon extra-contractual statements (by expressly disclaiming reliance upon any such statements), it is nonsensical to carve out fraud (at least the undefined or ill-defined variety) from the reach of the non-reliance clause:  “We didn’t rely upon any extra-contractual statements unless some were made and we in fact relied upon them” is one possible interpretation.  So should the deal point study have any bearing upon what a private equity seller’s proper response to the proposed insertion by the buyer of a fraud carve-out to a non-reliance clause should be?  The answer of course is absolutely no, unless you would have answered your mother’s question yes and were prepared to follow your friends off a bridge.  The fraud carve-out belongs in the exclusive remedy provision, and should never be a part of the non-reliance clause.^[8] 

The 2019 ABA Private Deal Point Study also tells us that 87% of the deals in the data set carved out fraud from the exclusive remedy provision.  Of that 87% of the deals, approximately 40% of the deals did not define the term fraud, while the remainder of that 87% defined it in some manner.  While its still remarkable that almost 40% of transactions in the data set fail to even attempt to define fraud given its vagaries and potential for mischief by those dissatisfied with the no indemnity or limited indemnity deal that was made, the number of deals that define fraud in some manner has increased substantially since 2006, when the percentage of deals with an undefined fraud carve-out, according to the ABA Private Target Deal Point Study, was 92%.  What the latest study does not reveal is how many of the so-called definitions of fraud address the issues that need to be addressed to limit fraud claims so that they are not simply a convenient end-run around the bargained-for benefit of the seller’s negotiated limits to or elimination of indemnification remedies.  A proper definition of Fraud should answer the following questions:

• What type of fraud claim is intended to be covered by the exclusion?  Just common law fraud, or is equitable fraud or promissory fraud intended to be covered?^[9]
• If limited to common law fraud, is it limited to deliberate, knowing misrepresentations, or does recklessness count?
• Whose fraud counts for purposes of a claim?  Is it just the named knowledge parties or any representatives of the sellers or target who may be deemed the sellers’ agents?
• Against whom can fraud claims be asserted? Any seller, or just the sellers who actually participated in the knowing conveyance of falsehoods?^[10]
• What is the source of the potential statements that can serve as basis for fraud claims?  Any statements, or only those specifically bargained for and made part of the written representations and warranties set forth in the agreement?
• Can fraud claims only be asserted as tort-based claims or are can they be asserted as an uncapped indemnification claims?

Nothing is more fundamental to sell-side private equity deal practice than the ability to distribute proceeds of a sale to the fund’s limited partners, subject only to the limited hold backs or escrows, if any, negotiated as part of any indemnification regime set forth in the acquisition agreement.  As noted in a prior post to Weil’s Global Private Equity blog:

The seller’s refusal to agree to an undefined fraud carve-out is not an indication that the seller wishes to deceive the buyer.  Quite the contrary; instead, it is the seller who doesn’t want to be deceived by the buyer into entering into an agreement (with agreed caps on liability) based on something that may or may not have been said by someone that is not written in the agreement, and of which the selling shareholders may not even be aware, and that the buyer may determine to use post closing to make a claim not subject to the cap.  And this is particularly true for the private equity seller concerned about post closing certainty in distributing proceeds to its limited partners.^[11]

Undefined fraud claims have “proven to be tough to define, 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.”^[12]  A well-crafted disclaimer of reliance clause that eliminates claims based upon things alleged to have been said, but which were not made part of the negotiated representations and warranty package, coupled with a well-defined fraud carve-out that is limited to false statements of fact set forth in the express representations and warranties (and which requires actual knowledge and fraudulent intent by the seller against whom the claim is to be made) remains an important part of standard  sell-side private equity practice, notwithstanding what deal points studies suggest other sellers may be doing in the market.  Deal professionals should never instruct their counsel to just do whatever is market.  Remember your mother’s admonishment and don’t follow market studies off a bridge.