A lot gets said by a lot of different people when selling a business. This is largely unavoidable in a full, negotiated sales process, as owners, management, investment bankers, employees, accountants, lawyers and others all convey information about the target company to the buyer or the buyer’s representatives. When a seller has to rely on others to respond to due diligence inquiries, it is all but impossible to monitor and confirm every statement and calculation. This process has the potential to result in the dissemination of information that may be incomplete or unintentionally misleading or, in the worst case scenario, intentionally false or misleading.
Private equity owners of companies for sale usually rely heavily on management and other employees to know, understand and communicate all aspects of the business. The risk of fraud is increased when management is eager to get a deal done, perhaps because such persons may participate in the sales proceeds, receive better employment packages and/or participate in the equity going forward. How, then, do owners ensure that they are not taking on liability for every statement made, and piece of information provided by, the company in the due diligence process? Luckily, there are protections—at least under some states’ laws—that can be built into the purchase agreement to address this risk. Specifically, Delaware has a significant amount of case law on point, providing sellers with a roadmap to the types of provisions necessary to protect themselves. However, the effectiveness of these provisions is dependent on the specific governing law for the purchase agreement as courts in some states have conclusively determined that there is no way to contract around fraudulent statements.
There are two basic conditions that need to be met in Delaware to absolve owners for false statements made during the due diligence process:
- The parties must be sophisticated.
- The parties must use unambiguous anti-reliance language in the acquisition agreement.
Importantly, even if those two conditions are met, a party cannot contract around fraud for statements made within the contract itself.
Assuming the parties are sophisticated, the question turns to what constitutes unambiguous anti-reliance language in an acquisition agreement regarding extra-contractual statements (that is, statements outside of the four corners of the document, such as information provided in due diligence). Sellers primarily use non-reliance clauses to define the universe of statements (i.e., representations) that the buyer can rely on in making its decision to consummate the transaction and, as a result, the universe of statements that can form the basis of fraud claims. Because reliance is a necessary factor in proving fraud, defining what statements the buyer did and/or did not rely upon in making its purchase decision can significantly reduce a seller’s risk.
The rules regarding the enforceability of these provisions and what the provisions do or do not need to say have evolved over time. For example, as recently as 2013, the Delaware Chancery Court instructed practitioners that anti-reliance provisions that addressed extra-contractual misrepresentations did not necessarily address extracontractual omissions.1 To successfully protect against an extra-contractual omission as creating the basis for a fraud claim, the court looked for a disclaimer as to the “accuracy and completeness” of extra-contractual statements or a more specific disclaimer as to extracontractual omissions.2 In November 2015, however, the same court determined that, when an agreement clearly defines the statements that can form the basis for a fraud claim (i.e., the representations and warranties contained in the agreement), a party cannot claim an extracontractual omission as the basis for pleading fraud even when the non-reliance language does not specifically address omissions, as every statement can be recast as an omission.3
The Delaware courts instruct us that there are no “magic words” that a seller needs to use in crafting a non-reliance provision as long as the words used create a clear antireliance clause. For instance, as noted above, the antireliance provision does not need to specifically reference omissions nor does it have to, despite one defendant’s arguments, be drafted in the negative (e.g., stating that the buyer “has not relied” on any other representations or warranties versus stating that the buyer “has only relied” on the representations or warranties in the agreement). In Delaware, the typical, successful formulation includes language providing that the seller is only making the representations and warranties contained in the agreement and no others and that those are the only representations and warranties that the buyer is relying on. Together with a standard merger/integration clause, this should unambiguously define the universe of information that the buyer can rely on for purposes of making a fraud claim. Below is the anti-reliance language from the November 2015 Prairie Capital case that provided a successful defense against extra-contractual fraudulent statements:
“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.”4
If the court were to allow the buyer to claim reliance on extra contractual statements in the face of the above language, then the buyer would have been in breach of that provision. This is referred to as the “double-liar” scenario that Delaware courts seek to avoid by enforcing these anti-reliance provisions. As noted above, though, not every jurisdiction views the double-liar problem as trumping public policy concerns regarding fraud (and at one point, Delaware did not either). So, although Delaware courts seem to be making it easier for sellers to contract around fraud for extra-contractual statements, it is important to check your governing law and to make sure that, if you are in Delaware (or a state with similar views on the subject), you include clear anti-reliance language. If you are a buyer and you cannot negotiate your way out of an anti-reliance provision, it is important that you include representations and warranties in the agreement for those items that are important enough for you to rely on.