Private Equity Sellers Must View “Fraud Carve-outs” with a Gimlet-Eye

In a March 3, 2016 post to Weil’s Private Equity Insights blog, it was suggested that the means of eliminating the specter of extra-contractual fraud claims is similar to the purported means of neutralizing a fictional zombie; both require a specialized weapon, skillfully wielded to deliver a decisive blow to exactly the right spot.  If that is true, agreeing to an undefined “fraud carve-out” to an exclusive remedies provision is like inviting a zombie to your home for dinner and forgetting that it wants to eat you.  If you must allow a zombie into your home, make sure you have limited its access and means of wreaking havoc.  Similarly, if you must agree to a fraud carve-out as a private equity seller make sure to define it properly so it does not gut the benefit of your non-reliance and liability limitation provisions.

In Prairie Capital III, LP v. Double E Holding Corp., decided in the Delaware Court of Chancery on November 24, 2105, Vice Chancellor Laster refused to allow an undefined fraud carve-out to an exclusive remedies provision to eviscerate the effect of an otherwise well-crafted non-reliance clause.  As noted in the December 1, 2015 post to Weil’s Private Equity Insights blog, the effect of that decision, at least in Delaware, is that “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 prior Insights blog posting warned, however, that this decision was “only one case in one jurisdiction, and it does not address the many other issues that can arise from such a carve-out,” and that this decision should not be taken as a “reason to allow the indiscriminate use of undefined fraud carve-outs.”  And to prove the point, on February 26, 2016, Vice Chancellor Noble issued his opinion in the Delaware Court of Chancery case of Haney v. Blackhawk Network Holdings, Inc. 

Haney involves an interesting twist on the typical scenario involving alleged fraud claims.  In this case, it is the selling stockholders (rather than the buyers) that alleged that they were defrauded in connection with an earn-out bargained-for as part of the purchase price.  And the allegations of fraud here were based upon extra-contractual representations by the buyers, not the contractual representations set forth in the written agreement.  Unlike in Prairie Capital, however, the so-called non-reliance clause in this case was found wanting because, although it suggested that no party was making any representations except for those specifically set forth in the merger agreement, it did not contain “express ‘anti-reliance’ language” and was instead deemed a mere “integration clause” that failed to contain language that was “an unambiguous acknowledgement by the plaintiffs that they were not relying on factual statements not contained within the [contract] itself.”  But the defendant buyers here argued that the exclusive remedy provision rescued any such alleged deficiency in the non-reliance/integration clause.

Unfortunately for the buyer, the relied-upon exclusive remedy provision contained an undefined fraud carve-out.  The buyer defendants argued that the only fraud claims permitted by virtue of the fraud carve-out to the exclusive remedy provision were fraud claims based upon the representations and warranties set forth in the merger agreement, not fraud claims premised upon extra-contractual statements.  Thus, whether or not there was an effective anti-reliance clause, the exclusive remedy provision made indemnification the sole remedy for any misstatement or omission within or outside the merger agreement, except for fraud claims related to the contractual representations and warranties.  But the court held that a reasonable reading of the fraud carve-out to the exclusive remedy provision, at least at the motion to dismiss stage, was that the fraud carve-out was not limited to fraud claims based on an alleged misstatement or omission with respect to the representations and warranties set forth in the merger agreement only, but extended to extra-contractual fraud claims as well.  Thus, in the absence of a limited definition of fraud, all fraud claims were fair game, regardless of the nature of the alleged fraud or the source of the alleged omissions or misstatements.  And, sure enough, one of the fraud claims made by the selling shareholders here was based upon the illusive concept of “equitable fraud.”  So, even had there been an effective disclaimer of extra-contractual representations, the undefined fraud carve-out might have still given rise to the argument that a breach of the contractual representations themselves could form a basis for an equitable fraud claim premised on negligence or inadvertence rather than intent to deceive.

Indeed, Haney reminds practitioners that “equitable fraud” is simply an action based upon a misstatement or omission of fact relied upon by the plaintiff to its detriment, without the requirement that the plaintiff “demonstrate that the misstatement or omission was made knowingly or recklessly.”  The only additional limitation on claims of equitable fraud is that the remedy being sought has to be an equitable remedy like rescission, reformation or a constructive trust (or the plaintiff has to have some special relationship with the defendant).  And lest you think this is just a Delaware thing, this quote from a recent New York case, Board of Managers of the Soundings Condominium v. Foerster, 2016 WL 698715 (N.Y. Sup. Ct. Feb. 23, 2016), should serve as a helpful reminder:

Fraud sufficient to support … rescission requires only a misrepresentation that induces a party to enter into a contract resulting in some detriment, and “unlike a cause of action in damages on the same ground, proof of scienter and pecuniary loss is not needed” (D’Angelo v. Bob Hastings Oldsmobile, Inc., 89 A.D.2d 785, 785 [4th Dept 1982], affd 59 N.Y.2d 773 [1983] ). Even an innocent misrepresentation will support rescission (see Seneca Wire & Mfg. Co. v. Leach & Co., 247 N.Y. 1, 8 [1928] ).

The dangers of undefined fraud carve-outs, together with alternative approaches to address legitimate buyer concerns, were discussed in detail in an August, 2014, The Business Lawyer article (available here).  Yet, even though more and more sellers are insisting on defining fraud so that it only includes deliberate misrepresentations involving an actual intention to deceive the buyer with respect only to the representations and warranties set forth in the purchase and sale agreement, some sellers continue to be willing to roll the dice on an undefined fraud carve-out.  The reasons continue be the same, the other side simply doesn’t understand why you need to define fraud, because “fraud is fraud.”  Equitable fraud is fraud too.  So are a lot of other things that you might not think of as constituting fraud.  Remember, also, that the scienter required to support a damage claim based on common law fraud is not limited to intentional misrepresentation, but also includes recklessness, which might include asserting the truth of a statement when you have no (or a limited) basis to make that assertion (even though you have no reason to believe it is not true).  And a claim of rescission, based on the non-scienter-based form of fraud, although not a technical claim for damages, can require the seller to return the purchase price paid.  These are all bad outcomes for the private equity seller making distributions to its limited partners.  Thus, more and more agreements, where there is any fraud carve-out at all, contain a limited definition of “fraud” similar to the following definition plucked from a publically available private company acquisition agreement entered into on January 22, 2016:

Fraud” means, with respect to a party, an actual and intentional fraud with respect to the making of the representations and warranties pursuant to Article III, IV or V (as applicable), provided that such actual and intentional fraud of the Seller, the Company or the Buyer, as the case may be, shall only be deemed to exist if any of the individuals included in the definition of “Knowledge” with respect to such party, as applicable, had actual knowledge (as opposed to imputed or constructive knowledge) that the representations and warranties made by such party pursuant to, in the case of the Seller, Article III as qualified by the Disclosure Schedules, in the case of the Company, Article IV as qualified by the Disclosure Schedules, or in the case of the Buyer, Article V, were actually breached when made, with the express intention that the other party rely thereon to its detriment.

And this definition is not introduced as the only way to accomplish the objective of limiting fraud claims to the truly egregious, deliberate lies relating to the bargained-for representations and warranties in the agreement, but as an indication that there are lots of examples out there, many of which can be found in the previously mentioned 2014 The Business Lawyer article, but many more of which are appearing every day in the changing market dynamics regarding this issue.

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.

While a “gimlet” is a cocktail made with gin and lime juice, which if consumed in the right quantity may result in one becoming bleary-eyed, the “gimlet” in the compound word “gimlet-eye,” used in the title to this piece, refers to the sharp, piercing tool used to bore small holes; thus, to view something with a gimlet-eye means a sharp, piercing and thorough review.  And having a gimlet-like tool handy at a dinner with a fictional zombie could be invaluable if that zombie suddenly decides to try and eat you.