A recent Delaware Court of Chancery decision involving the sale of a business by one private equity firm to another, Prairie Capital III, LP v. Double E Holding Corp., provides another opportunity to remind private equity sellers of the potential for dissatisfied buyers to use fraud claims (even if unfounded) to attempt to gut the indemnification caps and deductibles that were a fundamental part of the benefit of the bargain made by the selling private equity firm.
As noted in an August, 2009 The Business Lawyer article by this author, claims 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.
As noted in the October 26, 2015 post to Insights regarding the TrueBlue decision, “fraud is a many splendored thing.” And tort-based claims of fraud or misrepresentation can include intentional, reckless, negligent or even innocent misrepresentations of fact made either within or outside the written purchase and sale agreement. A well-crafted disclaimer of reliance provision can eliminate (in many but not all states) the specter of these claims being premised based upon statements made outside the bargained-for representations and warranties that were actually included in the written sale and purchase agreement. But many states (including Delaware) permit uncapped fraud claims to be premised on the representations and warranties that are contained within the written agreement itself notwithstanding an exclusive remedy provision that caps the contractual indemnification claims otherwise available for the breach of those same written representations and warranties. And that is true irrespective of whether there is a negotiated “fraud carve-out” to the exclusive remedy provision.
Some prior Delaware case law had suggested, however, that the existence of an undefined fraud carve-out to the exclusive remedy provision could cast doubt upon the efficacy of an otherwise robust disclaimer of reliance provision regarding extra-contractual representations, with the result being that uncapped fraud claims could be premised not only upon the representations and warranties set forth in the written agreement, but also upon purported statements made in the negotiations leading up to the execution of the written agreement. But, in Prairie Capital, Vice Chancellor Laster had a different take on the effect of an undefined fraud carve-out to the exclusive remedy provision (one more in line with the view of this author in the Fall, 2014 The Business Lawyer article on this subject): a fraud carve out to an exclusive remedy provisions permits the parties to ignore the limited contractual remedies when alleging fraud, but it does not expand the representations upon which those fraud claims may be premised if the agreement clearly limits reliance to only the express contractual representations made in the agreement. That of course is still no reason to allow the indiscriminate use of undefined fraud carve-outs. This is only one case in one jurisdiction, and it does not address the many other issues that can arise from such a carve-out. But it should be welcome news to sophisticated private equity sellers who need certainty as to post closing liability in order to make distributions to their limited partners.
Prairie Capital also contains a good reminder of the fact that, as a matter of law, individual deal professionals participating in the negotiation and decision making regarding a deal have personal liability for claims of fraud (or the various species of misrepresentation claims), even when those claims are based solely upon the representations and warranties set forth in the agreement as to which the limited right to indemnification is the sole contractual remedy. This is a good reason to try and mitigate not only the risk of a claim being lodged at all, but also limiting the persons against which such claims may be made. In other words, sell-side private equity firms should not only have robust anti-reliance and exclusive remedy provisions (with an appropriate defined fraud carve-out if desired), but also well-crafted non-recourse provisions that cover both contractual and tort-based claims.