Delaware Court of Chancery Broadens Scope of Language and Effect of Disclaimers of Reliance

Practical Law Legal Update w-001-0118 (Approx. 10 pages)

Delaware Court of Chancery Broadens Scope of Language and Effect of Disclaimers of Reliance

by Practical Law Corporate & Securities

Background

The litigation arose out of the sale of Double E Parent LLC, a portfolio company of private equity firm Prairie Capital Partners. The principal selling stockholders in the deal were Prairie Capital, III, L.P. and Prairie Capital III QP, L.P., which were funds sponsored by Prairie Capital Partners. The buyer was Double E Holding Corp., an acquisition vehicle formed by Incline Equity Partners, III, L.P, a fund sponsored by private equity firm Incline Equity Partners. The sale signed and closed on the same day pursuant to a stock purchase agreement dated April 4, 2012.

Prairie Capital decided to sell the company in the summer of 2011. Leading up to the sale, the company's financial advisor reached out to potential acquirers, including Incline, and pitched the company as a growth story. Central to the pitch was the image of the company as a cash-generating business that had an excellent track record for collecting accounts receivable. During its meetings with the advisor and company management, Incline focused on the company's revenue trends and the reliability of its figures, including its internal controls, its revenue recognition policies, and its compliance with GAAP.

In February 2012, with the sale process dragging on, the company's financial advisor contacted Incline and provided it with updated financial statements for the 2011 fiscal year and interim financial statements for January and February 2012. The financial statements corroborated the growth story pitched by the company. Incline made an offer, conditioned on conducting due diligence, verifying the accuracy of the 2011 financial statements, and waiting to see if the company would meet its sales goals through the end of March. Incline emphasized that it reserved the right to walk away or renegotiate the offer price if the sales goals were not met.

By mid-March, it became clear that the company was not going to meet the sales target that had been provided to Incline. Recognizing that the deal was in jeopardy, the company's CEO and CFO took steps to massage and ultimately falsify the company's financial statements. These acts included:

Providing Incline with a shipment forecast that reflected anticipated shipments for the balance of the month that would almost exactly match the March sales target, even as it implied shipping more product in the last eight days of the month than in the first 23 days.
Pressuring the company's employees to manufacture product and ship orders in March, while reassuring Incline that the company was meeting its March sales goals and that the company was operating in the ordinary course of business.
Identifying pending orders that were closest to their anticipated manufacture or shipping dates, generating false shipment entries to make it appear that those products had actually shipped, backdating these records to avoid arousing suspicion, producing false invoices and booking revenue in the company's accounts receivable.

All told, management fabricated roughly $650,000 of sales in March to make it appear that the company had met its target. The defendants believed that the fraud would not be discovered because the CEO and CFO would remain in their executive positions after the sale, allowing them to reconcile the company's records post-closing and make sure everything looked right.

In reliance on the information provided to it, Incline decided to buy the company. The parties executed the stock purchase agreement and closed on April 4, 2012. The SPA included representations and warranties for absence of changes outside the ordinary course of business, accounts receivable, financial statements and undisclosed liabilities, and compliance with laws. The SPA established an escrow fund to fund any indemnification obligations stemming from breach of representations and warranties. The SPA also contained an "Independent Investigation" provision that stated, in full:

"The Buyer acknowledges that it has conducted to its satisfaction an independent investigation of the financial condition, operations, assets, liabilities and properties of the Double E Companies. In making its determination to proceed with the Transaction, the Buyer has relied on (a) the results of its own independent investigation and (b) the representations and warranties of the Double E Parties expressly and specifically set forth in this Agreement, including the Schedules. SUCH REPRESENTATIONS AND WARRANTIES BY THE DOUBLE E PARTIES CONSTITUTE THE SOLE AND EXCLUSIVE REPRESENTATIONS AND WARRANTIES OF THE DOUBLE E PARTIES TO THE BUYER IN CONNECTION WITH THE TRANSACTION, AND THE BUYER UNDERSTANDS, ACKNOWLEDGES, AND AGREES THAT ALL OTHER REPRESENTATIONS AND WARRANTIES OF ANY KIND OR NATURE EXPRESS OR IMPLIED (INCLUDING, BUT NOT LIMITED TO, ANY RELATING TO THE FUTURE OR HISTORICAL FINANCIAL CONDITION, RESULTS OF OPERATIONS, ASSETS OR LIABILITIES OR PROSPECTS OF DOUBLE E AND THE SUBSIDIARIES) ARE SPECIFICALLY DISCLAIMED BY THE DOUBLE E PARTIES."

Two days before the funds in escrow were set to be released to the seller, Incline submitted a claim notice, which in part stated their belief that the company had engaged in fraud, which caused losses to the buyer.

When the escrow funds were not released, the sellers' representative filed suit against the buyer to compel the release of the escrow. The buyer counterclaimed, asserting, in part, a claim for fraud against Prairie Capital and the company's CEO and CFO, based on extra-contractual statements and omissions, and on the representations in the SPA listed above.

Outcome

The Chancery Court granted in part and dismissed in part the counterclaim defendants' motion to dismiss, finding that, at the pleading stage, the counterclaim plaintiffs had:

Waived their right to bring a claim of fraud regarding the company's extra-contractual representations and omissions.
Sufficiently plead their claim regarding breach of the representations in the SPA sections for absence of changes, accounts receivable and, to a limited extent, financial statements and undisclosed liabilities.
Shown that it was reasonably conceivable that the individual and selling-stockholder defendants could be held liable for the fraudulent contractual representations made by the company itself.

Fraud Claim Based on Extra-Contractual Representations Does Not Survive

The counterclaim plaintiffs based their fraud claim on both an extra-contractual element and the contractual representations in the SPA. The court only permitted the claims based on the representations in the SPA to survive at the pleading stage.

To succeed on a fraud claim, a plaintiff must show:

A false representation.
The defendant's knowledge or belief that the representation was false, or a reckless indifference to its truth.
The defendant's intention to induce action based on the representation.
A reasonable reliance by the plaintiff on the representation.
Causally related damages.

The counterclaim alleged that the seller parties fraudulently misrepresented to Incline, verbally and in written materials, that the company had met its sales targets in conformance with GAAP. While the misrepresentations may have indeed been fraudulent, the court ruled that the Independent Investigation provision foreclosed claims of fraud based on extra-contractual misrepresentations. In so ruling, the court relied on settled Delaware law, which enforces clauses that identify the specific information on which a party has relied and that foreclose reliance on other information (RAA Mgmt., LLC v. Savage Sports Hldgs., Inc., 45 A.3d 107, 118-19 (Del. 2012)).

To escape the effect of the Independent Investigation provision, Incline argued that its language did not amount to a clear anti-reliance clause of the type required by Delaware law. To this end, Incline relied on the court's decision in Anvil Holding Corp. v. Iron Acquisition Company, which held that two provisions in the contract in question were not specific enough to foreclose reliance on extra-contractual representations ( (Del. Ch. May 17, 2013)). Specifically, Incline argued—and the court acknowledged—that disclaimer clauses are often framed negatively (buyer is not relying on any representations not included in the agreement), yet the clause at issue here was phrased positively (buyer is only relying on the representations included in the agreement). Incline relied on this distinction to argue that the Independent Investigation clause did not bar their fraud claim because Incline did not disclaim reliance, but merely stated that Incline was relying on the information included in the SPA..

The court rejected this argument and Incline's interpretation of Anvil, emphasizing that it was irrelevant whether the disclaimer was phrased positively or negatively. Though it was framed in the affirmative sense, the court held that the clause had clearly defined the universe of information that Incline had relied on, and in so doing had excluded any other information on which Incline could state a claim. The court refused to read Anvil as requiring a specific formula such as the words "disclaim reliance" or any other "magic words." As the court put it, language is sufficiently powerful to reach the same ends by multiple means.

Ruling Echoes Practical Law 2013 Study

The study conducted by Practical Law in 2013 reached a similar conclusion about positively worded statements. In the section entitled Statements of Non-Reliance, the study observed that in Independent Investigation provisions, the buyer acknowledges that it has conducted its own investigation of the business being acquired. However, the study went on, it is not always perfectly clear if the buyer is using this provision to disclaim reliance, or is simply acknowledging that it has no complaints about the seller's conduct during the due-diligence process.

With that in mind, the study compared and contrasted two Independent Investigation provisions. In one agreement, the provision stated the following:

"Each Buyer has conducted its own independent investigation, review and analysis of the Business and the Acquired Assets, and acknowledges that it has been provided adequate access to the personnel, properties, assets, premises, books and records, and other documents and data of the Business for such purpose."

In the other agreement, the provision stated:

"Buyer acknowledges and agrees that it has conducted its own independent review and analysis of and, based thereon, has formed an independent judgment concerning, the business, assets, condition, operations and prospects of the Group Companies. In entering into this Agreement, Buyer has relied upon its own investigation and analysis and the representations and warranties of the Company and the Seller expressly set forth in this Agreement…"

As the study observed, in neither case did the buyer explicitly state that it is not relying on any statements of the seller not contained in the agreement. However, the study concluded that the second example should be counted for purposes of the survey as a statement of non-reliance. This was because the provision stated affirmatively that the buyer has relied on its own investigation—a phrase that carries a strong implication that it is not relying on any statements of the seller not contained in the agreement. The first example, on the other hand, did not contain any language of reliance at all. For that reason, it was not counted as a statement of non-reliance.

The Independent Investigation provision in Prairie Capital raises the same issue. Though not worded negatively, the provision contains the same statement, that Incline "has relied on" both its own investigation and the representations and warranties expressly set forth in the SPA. As the Practical Law study surmised, this type of statement should be—and now is—considered sufficiently clear to qualify as a disclaimer of reliance under Delaware law.

Fraud Claim Based on the Defendants' Omissions Does Not Survive

Incline also argued that even if the Independent Investigation provision functioned as a bar on claims based on extra-contractual misstatements, Incline could still bring a claim based on the sellers' omissions. Incline relied for this argument on the court's own decision in TransDigm Inc. v. Alcoa Global Fasteners, Inc., which held that even an adequate disclaimer of reliance does not bar claims of fraudulent concealment if the buyer has not disclaimed reliance on extra-contractual omissions ( (Del. Ch. May 29, 2013)). To bar claims of fraudulent concealment, the TransDigm court held, the buyer must also disclaim reliance on the accuracy and completeness of the information provided to it by the seller. Incline, however, had not made any such disclaimer.

The court in Prairie Capital declined to follow the reasoning in TransDigm, stating explicitly that "to the extent TransDigm suggests that an agreement must use a magic word like 'omissions,' then I respectfully disagree with that interpretation." Central to the Prairie Capital court's disagreement with TransDigm was its observation that every misrepresentation to some extent involves an omission of the truth. In the court's view, if a plaintiff could escape a disclaimer clause by reframing an extra-contractual misrepresentation as an omission to state the truth, then the disclaimer would be rendered irrelevant. The court therefore declined to follow TransDigm's ruling, holding instead that Incline's statement, which defined the universe of information that it was relying on, was sufficient to exclude a fraud claim based on an extra-contractual omission.

Reconciling Prairie Capital with TransDigm

Before Prairie Capital, other Delaware courts had already taken the view that TransDigm should not be read broadly. In ITW Global Investments Inc. v. American International Partners Capital Fund IV, L.P., the Delaware Superior Court declined to follow TransDigm, both on grounds that:

The issue in that case did not turn on a concealment claim.
A Delaware district court had cautioned that "the TransDigm exception is 'limited.'"

(, n.118 (Del. Super. Jun. 24, 2015), citing Universal Am. Corp. v. Partners Healthcare Solutions Hldgs., L.P., 61 F. Supp. 3d. 391, 400 (D. Del. 2014).)

The reasoning provided in both Universal American Corp. and Prairie Capital turned on the observation that every misrepresentation, to some extent, involves an omission of the truth, and can be creatively re-characterized as an omission.

This observation is particularly salient in Prairie Capital. In Prairie Capital, Incline "flipped the script," as the court put it, by recasting its claims of misstatements as claims of omissions. The counterclaim by Incline charged that the defendants had deliberately withheld and concealed from Incline that the company had not met its sales targets, had falsified its internal accounting records, and had drastically deviated from its own internal practices and procedures. In essence, then, the same underlying facts that gave rise to Incline's claims of misstatements triggered its claims of omissions. Each claim was just a mirror image of the other.

The omissions at issue in TransDigm, by contrast, were more substantial. In TransDigm, the buyer alleged that the seller had concealed the fact that it had offered a major customer a substantial discount and was at risk of losing about half of that customer's business. The TransDigm court reasoned that the buyer in that case could reasonably rely on the assumption that the seller had not actively concealed information or engaged in a scheme to hide that material information. The buyer's concealment claim amounted to more than a mere flip of the script of its previous claims.

In this regard, it is noteworthy that the Prairie Capital court itself acknowledges that once a party allows its counterparty to conduct an investigation, the party cannot conceal information. Conceivably, then, a claim that the seller has concealed material information, and which claim is more than a mirror-image restatement of the claims of reliance on misstatements, could survive a disclaimer provision that does not disclaim reliance on the accuracy or completeness of the seller's statements, even in the eyes of the Prairie Capital court.

That said, it seems more likely, in light of VC Laster's objection to a need for "magic words" and his willingness to interpret a disclaimer robustly, that he would not consider the "accuracy or completeness" phrase critical for disclaiming claims of fraudulent concealment. The split between the two decisions may ultimately require the input of the Delaware Supreme Court.

Exclusive Remedy Provision Does Not Affect Disclaimer Provision

Incline also argued that the exclusive remedy provision in the SPA was evidence that the SPA does not limit Incline's ability to sue for extra-contractual fraud. The provision stated:

"Except as provided in [sections relating to post-closing covenants and the payment of a specific note], equitable remedies that may be available, or in the case of fraud, the remedies set forth in this Article X [relating to indemnification] constitute the sole and exclusive remedies for recovery of Losses incurred after the Closing arising out of or relating to this Agreement and the Transaction."

By Incline's reading, because the provision states that contractual indemnification is not the sole and exclusive remedy in case of fraud, Incline must therefore have a right to bring fraud claims.

The court rejected this reading, finding that the exclusive remedy provision only stands for the notion that in case of fraud, the buyer is not limited to the contractual indemnification framework, but has other available remedies. The provision, however, does not address the representations that the buyer may rely on to establish a fraud claim. It does not make available to Incline any claims that Incline has already disclaimed elsewhere in the agreement.

Ruling Predicted in 2013 Study

The court's ruling on this point was also predicted in the 2013 study. In the Impact of Exclusive-Remedy Provision section, the study assumed that a carve-out for fraud from the exclusive-remedy provision will "probably not undo clear disclaimers of both extra-contractual representations and warranties and reliance." This assumption is now supported by the Prairie Capital decision.

Claims Based on Contractual Representations Survive

Incline also brought claims based on specific representations in the SPA. The court found that Incline had adequately plead that the absence of changes, accounts receivable, and a portion of the financial statements representations had been false when made. Central to Incline's claim was that the falsifying of the company's financial statements and sales figures, as well as the company's deviation from its ordinary course of business in its accounting policies, had amounted to breaches of these representations. The court strictly adhered to the language of the representations and did not permit the counterclaim plaintiffs to expand their claims in contract to periods of time preceding the scope of the representations.

Directors and Officers May Be Held Personally Liable for Corporation's Wrongful Act

The director and officer defendants challenged Incline's claim as applied to them, claiming that the company alone, and not the individual defendants, made the representations. The court dismissed this argument.

A party is held accountable for false representations if the misrepresentation, although not made directly to another, is made to a third person and the maker intends or has reason to expect that his representation will be communicated to the other, and that it will influence his conduct in a transaction (Restatement (Second) of Torts § 533). This rule is satisfied when an officer speaks on behalf of the corporation. A corporation is an artificial entity that can only act through its human agents. This is something that every human agent for the corporation understands; a director or officer therefore cannot escape personal liability if he actively participated in the fraud by claiming that he was simply acting for the corporation.

In Prairie Capital, the CEO and CFO were members of the transaction working group and monitored and directed the company's day-to-day activities. They spoke on behalf of the company during the negotiations and approved all documents and reports sent to the buyer. The Prairie Capital managing directors who were members of the company's board similarly communicated directly with management with the intention that their statements be repeated to the buyer. They oversaw the process and actively engaged in the preparation of presentation materials and approved the creation of false sales numbers.

The court therefore found that Incline's claim sufficiently alleged at the pleading stage that it is reasonably conceivable that the individual defendants could be found liable for the fraudulent contractual representations made by the company.

Practical Implications

The Prairie Capital decision effectively expands the scope of disclaimers of reliance. After a series of decisions in 2013 (as detailed in the study) that seemingly required more and more verbiage to construct an unimpeachable disclaimer, Prairie Capital confirms that a provision that can be read as strongly implying a disclaimer of reliance will be read that way, without requiring a particular framing or any "magic words."

As discussed above, the decision seemingly represents a split with the court's earlier TransDigm decision on the issue of disclaiming claims for fraudulent concealment. The split can potentially be avoided depending on the nature of the concealment claim, although it seems more likely that VC Laster would be skeptical of any such claim if the purchase agreement contains an otherwise robust disclaimer provision. The Delaware Supreme Court has ruled on disclaimers of reliance most recently in RAA Management, and may be called upon to rule on this issue too.

Delaware Court of Chancery Broadens Scope of Language and Effect of Disclaimers of Reliance | Practical Law