A New Reason for Private Equity Sellers to Hate Undefined “Fraud Carve-outs”

Undefined fraud carve-outs are ubiquitous in M&A agreements; and the problems they pose for private equity sellers are legion.  Many of these problems (together with suggested solutions) have been previously chronicled in a 2014 article in The Business Lawyer,1 as well as in a number of previous posts to Weil’s Private Equity Insights blog.2  But, a recent Delaware decision, EMSI Acquisition, Inc. v. Contrarian Funds, LLC, C.A. No. 12648-VCS (Del. Ch. May 3, 2017), provides yet another reason for private equity sellers to vigorously resist the inclusion of fraud carve-outs in M&A agreements, or to carefully define them so that the potential havoc they can wreak on deal certainty can be understood and managed.

The EMSI Acquisition Decision

In EMSI Acquisition, the Delaware Court of Chancery found that an undefined fraud carve-out contained within a stock purchase agreement was subject to the “reasonable construction” that it permitted uncapped, contractual indemnification claims against all of the shareholder sellers for the alleged fraud committed by the management of the company being sold (not just an uncapped claim for common law fraud against those sellers, if any, who participated in or had actual knowledge of the alleged fraud). According to the court, “‘[i]nelegant drafting’ has left the Court unable to definitively construe the indemnification provisions of the SPA in a manner that would enable final adjudication of this dispute at the pleading stage.”  As a result, the court will now proceed to an expensive and unpredictable trial where the court will “require extrinsic evidence to construe the ambiguous indemnification provisions” to determine the true meaning of the fraud carve-out set forth in the stock purchase agreement; and, from a deal certainty standpoint, the need for a trial is a loss for the sellers, even if the sellers ultimately prevail.

The sellers claimed that the undefined fraud carve-out from the otherwise exclusive indemnification regime, which was capped at an amount placed in an escrow fund, was intended to “honor Delaware’s public policy and the holding in Abry by preserving the parties’ rights to bring ‘a non-contractual claim based upon fraud’ outside the ‘strictures that apply to contractual indemnification claims.’”  In other words, the sellers’ position was that the fraud carve-out was intended to allow a claim for common law fraud against the sellers outside of the contractual indemnification mechanism, but not within it; and a fraud claim outside the contractual indemnification mechanism required the buyer to allege and prove that the sellers themselves engaged in the fraud.  With the exception of two of the sellers, who were members of the company’s management, the other stockholder sellers were institutional investors who had received their stock through a restructuring and had no involvement with the management of the company (thus, it is unlikely the buyer could have alleged participatory fraud against those institutional investors if forced to limit its claims to common law fraud outside the contractual indemnification provisions).  But alas, instead of limiting the breadth of the fraud carve-out to such circumstances, the sellers instead agreed to a broad, undefined fraud carve-out that provided that “[n]otwithstanding anything in this Agreement to the contrary (including . . . any limitations on remedies or recoveries . . .) nothing in this Agreement (or elsewhere) shall limit or restrict . . . any Indemnified Party’s right or ability to maintain or recover any amounts in connection with any action or claim based upon fraud  in connection with the transactions contemplated hereby.”  Not only did this broad fraud carve-out create ambiguity regarding whether fraud-based claims could be asserted on an uncapped basis within the indemnification framework notwithstanding other language clearly limiting indemnification claims to the escrow fund, it also opened up the question of whose fraud matters and what type of fraud was encompassed.  Indeed, the court suggested that a “claim based upon fraud” was not necessarily even limited to a “claim for fraud.”  Moreover, because any claim “based upon fraud,” within the indemnification framework, could be maintained against all of the sellers on an uncapped basis, a claim based solely upon the company’s alleged fraud could be premised solely upon the knowledge of the company’s employees, even if the sellers did not share that knowledge.

Even if the sellers prevail in their interpretation, the sellers appear to have held a somewhat flawed view of “Delaware’s public policy and the holding in Abry,” which they claim to have sought to honor with their “inelegantly” drafted fraud carve-out.  Delaware public policy does not require the preservation of all types of fraud claims, nor does it require the preservation of fraud claims based upon both extra-contractual and contractual representations.  And Abry very specifically permits selling shareholders to contractually allocate to the buyer the risk that the management of the company being sold may be intentionally misrepresenting facts to the buyer without the knowledge of the sellers.  What the Abry decision sought to do was to carefully balance the law’s abhorrence of deliberate fraud by a seller, with Delaware’s deep respect for the ability of sophisticated parties to make whatever bargain they desire to make.

Delaware’s Contractarian Principles and Abry’s Limited Public Policy Override

The Delaware judiciary is renowned for its contractarian approach to resolving contractual disputes; as a general rule, contracting parties are held to the bargains they make, according to the words they use, in the written agreements they negotiate and sign.  Sophisticated parties rely upon this contractarian approach in selecting Delaware law to govern their contracts.  This is particularly true for a private equity seller entering into a purchase agreement respecting the sale of a portfolio company.  Private equity sellers require certainty regarding post-closing exposure to claims when distributing the proceeds of a portfolio company sale to their limited partners.  And buyers compete in auctions of portfolio companies based on their stated risk tolerance and corresponding willingness to offer shorter periods during which any post-closing claims against the sellers may be made, as well as lower caps on the amount that may be recovered in the event of any such claims; indeed, in many instances, the winning bidder is the buyer who offers complete, “walk-away,” deal certainty, whereby the buyer agrees not to seek any post-closing remedy against the sellers at all (relying instead upon representation and warranty insurance or solely upon its own due diligence).

One notable exception to the reliability of Delaware’s contractarian principles occurs whenever one of the counterparties alleges that there was “fraud” in connection with the bargain otherwise made in and evidenced by a written agreement.  In the absence of approved contractual safeguards, the mere allegation of “fraud” can wreak havoc with the deal certainty otherwise obtained by a private equity seller in the written purchase agreement, leading to expensive and lengthy litigation, with the risk of an erroneous conclusion that fraud occurred and was chargeable to the private equity seller;3 and as Vice Chancellor Parson noted in Transdigm Inc. v. Alcoa Global Fasteners, Inc.,4 claims by a buyer that the seller committed fraud in connection with an M&A transaction are “regrettably familiar.” But even in recognizing claims of fraud as an exception to basic contractarian principles, the Delaware courts have sanctioned particular contractual provisions between sophisticated parties that are specifically designed to preclude certain types of fraud claims from intruding into a carefully crafted written agreement.  The sanctioned contractual provisions include “non-reliance clauses,” which are designed to preclude any fraud claim based upon alleged extra-contractual representations made outside the four corners of the written agreement, and “exclusive remedy provisions,” which are designed to preclude extra-contractual claims beyond the bargained-for contractual indemnification (with its agreed-upon deductibles from and caps on recoverable losses).

In sanctioning these contractual safeguards designed to limit fraud claims, however, the Delaware courts have established a clear demarcation between fraud claims that can be precluded contractually and those which cannot.  In the seminal Delaware decision of ABRY Partners V, L.P. v. F & W Acquisition LLC,5  then Vice Chancellor Strine specifically recognized that any fraud claim based upon an alleged extra-contractual representation of purported fact may be effectively precluded by use of a “non-reliance clause,” pursuant to which the buyer specifically disclaims reliance upon any such extra-contractual statements; and it matters not what the state of mind of the speaker of any such purported extra-contractual statement may be, as long as the recipient of that statement expressly disclaims reliance upon any such statements. But Delaware public policy does not permit the enforcement of a contractual provision that “purports to limit the [s]eller’s exposure for its own conscious participation in the communication of lies to the [b]uyer” in the written agreement itself.Thus, if a fraud claim is based on statements of purported fact set forth in the written agreement (rather than extra-contractual statements) and “the [s]eller knew that the [portfolio] [c]ompany’s contractual representations and warranties were false” or “the [s]eller itself lied to the [b]uyer about a contractual representation and warranty,”7 then the remedies available for any such purported fraud cannot be contractually limited solely to the agreed indemnification regime. In other words, contractual provisions that purport to limit fraud claims premised upon representations contained within the agreement itself, which the seller knows to be false, whether it or the portfolio company is the actual speaker, are presumptively ineffective.  But, it is perfectly permissible for parties to contractually “allocate the risk of intentional lies by the [portfolio] [c]ompany’s managers to the [b]uyer,” where the seller was unaware of such lies, as well as to contractually allocate to the buyer the risk of “reckless, grossly negligent, negligent, or innocent misrepresentations of fact” by the seller or the portfolio company.8  In most cases, a private equity seller is merely an investor in, rather than an operator of, the portfolio company, even when the private equity firm’s deal professionals are on the board of or hold certain officer titles with the portfolio company.  As a result, this judicially created, limited fraud exception, to the otherwise inviolate contractarian approach (requiring actual lies to be communicated by the private equity seller, or by the portfolio company with knowledge of the private equity seller, in the written agreement itself), is at least manageable by private equity sellers.

Contractual Fraud Carve-outs Can Do More than Merely “Honor” Abry’s Limited Public Policy Override

The very contractual freedom that is encouraged by Delaware’s contractarian principles can have potentially unintended consequences, however, when parties add their own contractual fraud exception, which is not necessarily limited to the same extent as the judicially created exception regarding the conveyance, by the seller to the buyer, of knowing lies in the contract.  Buyers say they need these contractual carve-outs to ensure that that they are not defrauded;9  and many sellers agree to them assuming that they are only agreeing to carve-out contractually that which is already carved out judicially.  But contractual fraud carve-outs tend to be undefined (although knowledgeable private equity lawyers insist on their being defined whenever possible), and an undefined fraud carve-out raises the specter of fraud claims based on something less than actual lying by the private equity seller itself, with the subject matter of the alleged fraud potentially including extra-contractual, rather than just contractual, representations.  Indeed, fraud claims can be premised on reckless, not just intentional, misrepresentations; and even completely innocent misrepresentations can constitute a type of fraud (so-called “equitable fraud”).  And EMSI Acquisition suggests that the caps on contractual indemnification payable by the sellers may be eliminated by such carve-outs not only for the alleged fraud of the seller itself, but also of portfolio company managers of which the seller was unaware (and a claim “based on fraud” may be something that does not even constitute a “claim of fraud” or a “claim for fraud”).

Most of these identified problems with the ubiquitous, undefined fraud carve-out are not new; and deal practice has evolved to the point where many agreements now define “fraud” for the purpose of any fraud carve-out.  For those truly wishing to merely honor Abry’s limited public policy override, of course, no fraud carve-out is even necessary, as it is judicially built into any written agreement governed by Delaware law. Moreover, including a carefully defined fraud carve-out and permitting uncapped indemnification with respect to such defined claims for fraud, rather than only a common law fraud claim outside of the indemnification framework, is not necessarily a flawed approach, particularly if the defined fraud being carved-out encompasses agreed situations beyond Abry’s judicially created fraud carve-out (e.g., where each seller agrees to a proceeds received cap for the fraud of certain named individuals and not just their own fraud).

Best Practices

As EMSI Acquisition indicates, undefined fraud carve-outs can do real damage to the deal certainty that is of paramount concern to a private equity seller. While the buyer has legitimate concerns about protecting itself from lies being told by the sellers about specific matters within the particular knowledge of the sellers, and which were agreed to be the subject of the negotiated representations and warranties set forth in the written agreement, the sellers also have a legitimate concern about accusations of fraud based on extra-contractual statements that were not included as part of the negotiated contractual representations and warranties, as well as about exposure for uncapped claims premised upon the alleged fraud of others and the fact that fraud is not necessarily limited to the egregious lying type of fraud that deal professionals sometimes assume.

If you really have to include a contractual fraud carve-out in your M&A agreements, define fraud so that it is limited to the truly egregious type of fraud, take special care that the fraud of others is not attributed to you (unless you have specifically identified certain named individuals that you are prepared to treat as your agents and thereby be responsible for), and determine whether the claims for defined fraud must be made as tort-based claims outside the indemnification framework, or must instead be made within the indemnification framework, even though the cap may be removed or enlarged in case of claims for such defined fraud.  An example of a simple defined fraud carve-out to the exclusive remedies provision (and these can be much more elaborate), which was derived from a publicly available M&A agreement and which attempts to accomplish many of these objectives, is set forth below:

Nothing herein shall operate to limit the common law liability of any Seller to Purchasers for fraud in the event such Seller is finally determined by a court of competent jurisdiction to have willfully and knowingly committed fraud against any Purchaser, with the specific intent to deceive and mislead any Purchaser, regarding the representations and warranties made in this Agreement.

Although the market has moved significantly toward defining fraud for the purpose of exclusive remedy carve-outs, there remain those buyers who are or claim ignorance of that market movement or of the issues undefined carve-outs can create.  But to maintain as much deal certainty as is legally permissible for the private equity seller, it is important that these buyers be educated and that sellers’ counsel remain vigilant about insisting on appropriate definitions that protect the buyers from real fraud by the sellers respecting the negotiated factual predicates that are contained within the written agreement, but which do not permit disappointed buyers to ignore the contractually bargained-for limits on post-closing claims in the absence of such real fraud by the sellers.



  1. See Glenn D. West, That Pesky Little Thing Called Fraud:  An Examination of Buyers’ Insistence Upon (and Sellers’ Too Ready Acceptance of) Undefined “Fraud Carve-Outs” in Acquisition Agreements, 69 Bus. Law. 1049 (2014).
  2. See e.g., Glenn West, Private Equity Sellers Must View “Fraud Carve-outs” with a Gimlet-Eye, Weil Insights, Weil’s Global Private Equity Watch, March 16, 2016;  Glenn West, The Surprising Connection Between an Extra-Contractual Fraud Claim and a Flesh-Eating Zombie, Weil Insights, Weil’s Global Private Equity Watch, March 3, 2016; Glenn West, Exclusive Remedy Provisions, Fraud Carve-outs, and Personal Liability for Sell-Side Private Equity Professionals, Weil Insights, Weil’s Global Private Equity Watch, December 1, 2015;  Glenn West, Promissory Fraud, Anti-reliance and the Dreaded “Undefined” Fraud Carve-out, Weil Insights, Weil’s Global Private Equity Watch, October 26, 2015; see also, Glenn West, Reps and Warranties Redux—A New English Case, An Old Debate Regarding a Distinction With or Without a Difference, Weil Insights, Weil’s Global Private Equity Watch, August 2, 2016.
  3. See generally, Glenn D. West & W. Benton Lewis, Jr., Contracting to Avoid Extra-Contractual Liability—Can Your Contractual Deal Ever Be the “Entire” Deal?,  64 Bus. Law. 999 (2009).
  4. C.A. No. 7135-VCP, 2013 WL 2326881, at *1 (Del. Ch. May 29, 2013).
  5. 891 A.2d 1032, 1034 (Del. Ch. 2006).
  6. Id. at 1064.
  7. Id.
  8. Id. at 1063.
  9. See Timothy A. Miller, How M&A Buyers Can Guard Against Extracontractual Fraud, Law360 (March 6, 2017, 11:32 AM EDT).