The use by purchasers of comprehensive due diligence request lists and carefully crafted representations and warranties is a staple of M&A transactions. Yet in deals where the seller will retain an interest in the success of the business going forward, such as where the seller receives equity in the purchaser or a right to a potential earnout as part of its consideration, the seller should likewise avail itself of these safeguards. The best protection is a representation regarding any critical issue; however, as a recent case before the Delaware Chancery Court shows, in the absence of such a representation, a party’s failure to document that it at least asked appropriate questions during due diligence may be fatal to its ability to later maintain actions for fraud.
In Airborne Health, Inc. v. Squid Soap, LP, the Delaware Chancery Court rejected the seller’s claims that the purchaser committed extra-contractual common law fraud, causing the seller to lose potential earn-out payments. The seller claimed that the purchaser, throughout the parties’ courtship, touted its strong brand name and ability to grow the seller’s business and failed to disclose pending legal proceedings threatening the purchaser’s continued success.
Counting on the success of its products in Airborne’s, Squid Soap sold its business to Airborne for $1 million in cash at closing, plus the potential for earn-out payments of up to $26.5 million if the business achieved certain post-closing targets. Squid Soap contended that its faith in Airborne was based, at least in part, on Airborne’s repeated boasts about its ability to leverage its strong brand name and market presence to sell Squid Soap’s products. However, at the same time it was making these statements, Airborne was the subject of a class action in California alleging various claims for false advertising, consumer fraud and unfair business practices, as well as an investigation by the Federal Trade Commission. Nine months after closing its acquisition of Squid Soap’s business, Airborne settled the California class action for $23.5 million. Following the settlement, the FTC and thirty-two state attorneys general filed actions with similar claims, resulting in further bad publicity and liabilities for Airborne.
The resulting fall-out for Airborne’s business hampered its ability to sell Squid Soap products, which diminished Squid Soap’s potential for an earn-out payment under the purchase agreement. Squid Soap alleged that Airborne’s boasts about its customer loyalty and marketing prowess, and its failure to disclose the presence of the pending litigation and investigation, constituted common-law fraud. The court rejected these claims, reasoning that under Delaware law, vague statements of corporate abilities or optimism, like those made by Airborne, are mere “puffery” and do not amount to fraud.
In addition, the court found that Airborne’s failure to disclose the pending litigation and investigations was not fraudulent because Airborne did not actively conceal those matters nor, in an arm’s length relationship, did Airborne have a duty to disclose the matters to Squid Soap. As the court pointed out, Squid Soap could have protected itself by conducting its own due diligence review of Airborne since, at the time of the transaction, the California class action had been filed and information regarding the action was publicly available. The court also noted that Squid Soap could have obtained a representation and warranty in the purchase agreement that would have required Airborne to make the desired disclosure. Instead, the only relevant representation in the purchase agreement required Airborne to say only that there was no litigation “reasonably likely to prohibit or restrain the ability of Purchaser to enter into this Agreement or consummate the transactions contemplated hereby.” Most fundamentally, Vice Chancellor Laster commented that “Squid Soap could have learned about all of Airborne’s litigation exposure through the simple expedient of asking Airborne.”
Ultimately, the court’s ruling in Airborne underscores the importance of sell-side due diligence in transactions where the seller will have a continued interest in the profitability of the business going forward, as in the case of an earn-out. A potential transaction partner may boast about its business without committing fraud and, in an arm’s length transaction, has no duty to disclose matters unless asked. As a result, sellers, as well as purchasers, should protect themselves through due diligence and appropriately tailored representations and warranties.