In most private company acquisition agreements, the seller bargains for an agreed cap and deductible on the extent of the seller’s indemnification obligation to the buyer arising from the buyer’s claims that the seller breached any of the specific representations and warranties set forth in the agreement. Many agreements, however, have carve-outs to these caps and deductibles, for claims based on “fraud.” While seemingly reasonable, these carve-outs can encompass claims that exceed the ordinary idea of what constitutes fraud. As was noted in an August, 2014, The Business Lawyer article by this author, “fraud is a many splendored thing” and failing to define it may make the carve-out encompass extra-contractual statements that were specifically not made part of the bargained-for representations and warranties set forth in the agreement.
Claims of extra-contractual fraud, whether they be based upon common law fraud, equitable fraud, failure to disclose fraud, active concealment fraud, or promissory fraud, can only be defeated contractually by a clear and robust disclaimer of reliance clause, to the extent the state law allows such claims to be defeated contractually at all (New York, Texas, Rhode Island, and Delaware all allow well-crafted anti-reliance clauses to avoid such claims in most circumstances, while states like Massachusetts and California are more chary, and Florida appears to require the actual use of the word “fraud” in the disclaimer provision to be effective). Sellers often rely on the contractual liability caps in making distributions to their LPs post closing; and a claim of extra-contractual fraud by the buyer designed to end-run the contractual liability caps can be a very unwelcome surprise, particularly when it is based upon the extra-contractual statements or actions of the members of management that now work for the buyer. The recent Delaware Superior Court case TrueBlue, Inc. v. Leeds Equity Partners IV, LP, illustrates this phenomenon. TrueBlue involves an unusual type of fraud claim—promissory fraud—made by a buyer against a private equity seller. In this case, the claim survived a motion to dismiss because the non-reliance clause, although robust, failed to clearly disclaim reliance, and because of the existence of a dreaded “undefined fraud carve-out.”
In TrueBlue, the claimed fraud was that the seller purportedly represented to the buyer (extra-contractually) that it would pay an earn-out payment to the extent it became due and owing by the purchased company’s subsidiary after the closing date. This is classic promissory fraud—i.e., making a promise of future performance without (allegedly) a present intention of fulfilling the future promised performance. The Stock Purchase Agreement, however, clearly listed the potential earn-out payment as an excepted liability from the contractual representations and warranties and failed to provide that it was a retained liability for which the seller would be liable, when a separate and distinct earn-out payment was in fact specifically listed as a retained liability for which the seller would be liable. Indeed, the court had no difficulty ruling that the contract was an integrated agreement and, by its express terms, the disputed earn-out liability was a liability of the subsidiary of the purchased company, not the seller. But, the court separately held that the promissory fraud claim could nonetheless proceed based on the pleadings.
The Stock Purchase Agreement’s so-called anti-reliance clause read as follows:
The Purchaser acknowledges that neither the Company, nor any of its Subsidiaries nor any seller nor any other Person . . . makes, or has made, any representation or warranty with respect to . . . information or documents made available to the Purchaser or its counsel, accountants or advisors with respect to the Company, its Subsidiaries or any of their respective businesses, assets, liabilities or operations. …The Purchaser acknowledges and agrees that the representations and warranties set forth in this Agreement (as qualified by the Schedules) supersede, replace and nullify in every respect the data set forth in any other document, material or statement, whether written or oral, made available to the Purchaser.
Although this clause seems to fairly and robustly disclaim that there were any representations or warranties made by the seller other than the ones made in the Agreement, the clause fails to specifically disclaim any reliance upon any representations that may have in fact been made notwithstanding the buyer’s agreement that no such representations were in fact made. While this may seem bizarre—that the court wants a specific disclaimer of reliance upon representations that the buyer has already said were not in fact made at all—that is the clear holding of many courts. You have to use the word “rely” or “reliance” in these provisions so you can specifically defeat the “justifiable reliance” element of most fraud claims.
But as an additional basis for its holding, the court also noted that the parties had contractually agreed that fraud claims would always be available to either party to the agreement. The Stock Purchase Agreement contained an undefined fraud carve out provision that read as follows:
Notwithstanding anything to the contrary herein, the existence of this ARTICLE VIII or Section 6.4 and of the rights and restrictions set forth therein and elsewhere in this Agreement do not limit any legal remedy against any Party hereto to the extent such Party has committed actual fraud against the Party seeking such legal remedy.
Many say that you can never premise a fraud claim upon a contractual promise of future performance because a fraud claim requires a misrepresentation of present fact. But this belief is based upon some confusing precedents that state that a plaintiff is prohibited from “bootstrapping” claims based upon breach of contract into a claim of fraud merely by saying that they were fraudulently induced by the alleged insincere contractual promise of future performance. The fact remains that you may well be able to allege a fraud claim based on an extra-contractual undertaking or representation, whether it’s repeated in the contract or even if it isn’t, if you allege that the promise was made extra-contractually and at the time of the undertaking or representation regarding future performance there was no intention to perform it.