Negotiated private company acquisitions frequently require sellers to indemnify the buyer for losses resulting from breaches of the seller’s and target company’s representations and warranties, subject to negotiated maximum limits or “caps.”
The indemnification provisions frequently provide carve-outs from the indemnification cap for fraud or intentional breach of the representations — this is a core issue in mergers and acquisitions.
A recent Delaware Chancery Court decision, EMSI Acquisition Inc. v. Contrarian Funds, highlights a potential trap for unwary selling shareholders — a situation where the target’s management engaged in fraudulent conduct without the selling shareholders’ knowledge.1
Delaware M&A law, following the Chancery Court’s landmark 2006 opinion in Abry Partners V LP v. F&W Acquisition LLC, provides that the exclusive remedy provision in an acquisition agreement that limits the buyer’s recovery to the agreement’s indemnification provision will not defeat a fraud-based claim for rescission or damages, where the “seller acted with an illicit state of mind, in the sense the seller knew” that its or the target company’s representations and warranties were false.2
The EMSI court, relying on Abry, found that the fraud exception contained in the exclusive remedy provision of the acquisition agreement may be construed to relieve the buyer from the cap on indemnification claims against an innocent seller if the facts giving rise to the breach involved management’s fraud.
Although EMSI appears to have been decided incorrectly, selling shareholders and their counsel must carefully address the innocent selling shareholder’s maximum liability for indemnification in situations where another selling shareholder or the target’s management may have known that the target’s representations or warranties were incorrect.
One approach is to clearly provide that an individual seller will only be subject to the indemnity cap’s fraud exception if that seller acted with an illicit state of mind and consciously knew that the representation was false.
EMSI Holding Co. is a medical information services company whose stock was mostly held by a group of institutional shareholders that received their shares in an out-of-court debt restructuring in 2005. The institutional shareholders were not active in EMSI’s management and desired to liquidate their equity positions as soon as practical.
After two unsuccessful sale processes in 2009 and 2012, EMSI decided to explore a sale in 2015 and began the process by releasing a confidential information memorandum April 30, 2015.
The offering document projected a rosy outlook for EMSI’s future, even though this was out of line with historical trends, including a decline in the company’s profitability for the most recent fiscal year.
Private equity firm Beecken Petty O’Keefe & Co. responded to the offering in summer 2015 and the parties negotiated a stock purchase agreement that is typical for a private company acquisition involving outside, passive selling shareholders. The stock purchase agreement distinguished between the sellers and the company.
Article III of the purchase agreement contained limited representations by the sellers, which is not surprising given that the institutional shareholders were passive investors in, not managers of, the company.
Article IV of the purchase agreement contained the company’s more expansive, but again typical, representations and warranties about the company and its business. These representations included that the financial statements were been prepared in accordance with generally accepted accounting principles on a consistent basis and that there has been no change in any significant respect in any business practice or accounting methods since the date of the most recent audited financial statements.
In Article V, the buyer represented that it was only relying on the promises and representations contained in the purchase agreement in a straightforward nonreliance provision.
Article X of the purchase agreement contained a typical, comprehensive, indemnification regime. The sellers’ indemnification obligations are set forth in Section 10.2:
Subject to the other provisions of this Article X, (including, without limitation, Section 10.4), each seller shall ... indemnify and hold harmless ... the “buyer indemnified parties” ... from any and all losses which any of the buyer indemnified parties may sustain arising out of: (a) any breach of any representation or warranty of such seller or the company contained in this agreement [emphasis added].
The limits upon the sellers’ indemnification obligations, including a cap providing that the escrow fund is the sole source of funds for payment, are provided in Section 10.4:
Notwithstanding anything to the contrary in this agreement (including, without limitation, Section 10.2) ... :(b) The buyer indemnified parties shall not be entitled to indemnification under Section 10.2(a) for any and all losses unless and until the aggregate amount of all of the losses ... for which the buyer indemnified parties would otherwise be entitled to indemnification pursuant to Section 10.2(a) exceed $450,000 (the “basket amount”), in which event, subject to the terms of this Article X and the escrow agreement, the buyer indemnified parties will be entitled to be indemnified in accordance with Section 10.2(a) for such losses ... in excess of the basket amount to the extent of, and exclusively from, any then-remaining escrow funds [emphasis added].
Section 10.4(d) further limits the sellers’ indemnification liability to the amount of the set-aside escrow funds by providing that, “[n]otwithstanding anything to the contrary in this agreement”:
The buyer indemnified parties shall only be entitled to indemnification (i) with respect to losses in respect of the representations and warranties (other than the excluded representations and the specific indemnity items) to the extent of, and exclusively from, any then-remaining escrow funds [emphasis added].
Section 10.10(a) makes clear that indemnification is the exclusive remedy for a seller’s breach of a representation, warranty or covenant:
From and after closing (except ... in the case of claims for fraud or willful or intentional misrepresentation), the sole and exclusive remedy of the seller indemnified parties and the buyer indemnified parties for any breach or inaccuracy, or alleged breach or inaccuracy, of any representation, warranty or covenant under, or for any other claims arising in connection with, any of the transaction documents, other than specific performance, shall be indemnification in accordance with this Article X, subject to the limitations set forth herein [emphasis added].
Section 10.10(b) of the purchase agreement then appears to carve out from the exclusive remedy limitation “any” claim “based upon fraud”:
Notwithstanding anything in this agreement to the contrary (including ... any limitations on remedies or recoveries...) nothing in this agreement (or elsewhere) shall limit or restrict (i) any indemnified party’s rights or ability to maintain or recover any amounts in connection with any action or claim based upon fraud in connection with the transactions contemplated hereby [emphasis added].
The sellers included the institutional shareholders and the members of EMSI’s management who also owned equity. The purchase agreement provided for an $85 million purchase price, with $9.5 million of the proceeds held in escrow to fund indemnification obligations.
The purchase agreement provided for a typical post-closing purchase price adjustment if the actual working capital at closing was more or less than the target amount. The purchase agreement appointed an independent accounting firm to resolve disputes regarding the working capital calculation.
Any purchase price adjustment was to be paid from the escrow fund. “For the avoidance of doubt,” the purchase agreement stated that “to the extent the then-remaining escrow funds are insufficient to pay the full amount of any deficiency, no seller ... will have any liability to buyer for such deficiency.”3
After the sale closed, EMSI’s financial performance dramatically declined, which was a sharp contrast from the bright future the company had forecasted throughout the sale process.
This prompted the buyer to conduct a forensic investigation, which revealed, at least according to the buyer’s experts, that the company “was ready to implode because of months of financial manipulation, acceleration of revenue, and recognition of sham revenue and earnings.”4
After realizing that it had received substantially less than the bargained for working capital amount, the buyer invoked a contractual provision providing for an independent accountant to determine the amount of the net working capital shortfall and the purchase price adjustment.
The accountant determined a working capital adjustment of $9.9 million in favor of the buyer, which exceeded the $9.5 million that was placed in escrow and was the negotiated contractual cap on the purchase price adjustment.
The buyer filed suit in Delaware Chancery Court against all the sellers, including the institutional shareholders and the management shareholders.
The buyer sought to recover the working capital price adjustment in excess of the escrow fund and recover the inflated price it paid as a result of the company’s fraud through the indemnification provisions in the purchase agreement.
The buyer’s complaint alleges that EMSI’s employees knowingly manipulated the work in process prior to the sale.
The buyer alleges that EMSI’s management engaged in financial fraud by inflating volume prices, accelerating revenue recognition for projects the company was not yet working on, overstating assumptions about what percentage of contracts would be completed and falsifying its progress on ongoing projects.
The buyer’s complaint also refers to a number of specific emails from officers on EMSI’s accounting staff to buttress its allegation that the company’s work in process was manipulated in order to overstate the company’s profitability.
Noticeably absent from the buyer’s complaint is any allegation that the institutional shareholders knew of, encouraged or participated in the fraudulent conduct.
The institutional shareholders promptly moved to dismiss the buyer’s claims on the ground that the purchase agreement expressly limited the buyer’s recovery to the now-depleted escrow fund.
The institutional shareholders argued that the Chancery Court should respect and enforce the contractually negotiated allocation of risk between a sophisticated buyer and sophisticated sellers who are both represented by knowledgeable M&A counsel.
Vice Chancellor Joseph R. Slights III addressed the issue within the context of a motion to dismiss, which helps explain the unexpected outcome.
Under Court of Chancery Rule 12(b)(6), the court must draw all reasonable inferences in favor of the nonmoving party, and dismissal is inappropriate unless the plaintiff would not be entitled to recover under any reasonably conceivable set of circumstances susceptible of proof.
Questions involving contract interpretation can be answered on a motion to dismiss when the contract’s language is plain and unambiguous. But dismissal of a contract dispute under Rule 12(b)(6) is proper only if the defendants’ interpretation is the only reasonable construction as a matter of law.
If the plaintiff has offered a reasonable construction of the contract, and that construction supports the claims asserted in the complaint, then the court must deny the motion to dismiss even if the defendant’s construction is also reasonable.
That said, Vice Chancellor Slights appears to have misunderstood the distinction between the two separate and independent exceptions for fraud commonly found in the indemnification provisions of negotiated acquisition agreements: the fraud carve-out from the cap on the sellers’ contractual indemnification liability for losses resulting from a breach of representations and warranties, as opposed to the carve-out for fraud claims from the provision providing that the purchase agreement’s indemnification provision is the buyer’s exclusive remedy.
Vice Chancellor Slights began his legal analysis in EMSI with a discussion of former Chancellor Leo G. Strine’s opinion in Abry, which the institutional shareholders say was a roadmap for the provisions they bargained for in the purchase agreement.
The complaint in Abry sought either a rescission of the acquisition or damages, because the selling shareholder allegedly made intentionally false representations and warranties in the acquisition agreement.
The buyer alleged that the fraud allowed it to avoid limitations in the agreement that precluded the buyer from pursuing rescission or damages based on fraud and capped damages for indemnification at $20 million, the amount placed in escrow to cover any of the buyer’s post-closing claims.
The seller disagreed and said the parties had agreed that the seller’s risk for indemnification would be capped in all instances at the amount the seller had bargained for: $20 million.
The Abry court balanced Delaware’s strong contractarian preferences against the state’s well-settled public policy that abhors fraud, and concluded that “to the extent that the stock purchase agreement purports to limit the seller’s exposure for its own conscious participation in the communication of lies to the buyer,” the provision was void as a matter of law.5
Accordingly, the Abry court declined to dismiss the buyer’s fraud claim against the seller.
But the Abry decision made clear that the claim survived because the buyer had pleaded facts that allowed a reasonable inference either that the seller knew that the representations and warranties made by the company were false or that the seller itself had made fraudulent representations and warranties.
In this regard, Abry emphasized that the buyer could avoid the bargained-for limits on its remedies only if it could prove that the seller acted with an “illicit state of mind”; otherwise, if the buyer’s proof revealed only that the company had misrepresented facts without the seller’s knowledge of the falsity, then the buyer would be limited to the bargained-for indemnity claim and its associated limitations.
Vice Chancellor Slights found that Abry provided a solid analytical framework within which to analyze the arguments of buyers and sellers who seek to exploit the risk allocation provisions of their transactional agreements, bargained-for on a clear day but deployed in the midst of post-closing controversy.
How the Decisions Compare
The vice chancellor’s reliance on Abry appears to be misplaced because Abry involved a fraud-based rescission claim where the “seller acted with an illicit state of mind, in the sense the seller knew that the representation was false and either communicated it to the buyer directly itself or knew that the company had.”
The Abry decision focused on the exclusive remedy provision, which establishes an indemnity action as the sole remedy both with respect to the stock purchase agreement and the sale contemplated thereby.
EMSI is clearly distinguishable because the institutional shareholders never participated in fraud or had an illicit state of mind.
The case is also distinguishable because the buyer seeks to pursue the contractual indemnity claim under the purchase agreement rather than pursue a separate, independent fraud-based claim, and wants to set aside the negotiated cap on contractual indemnity liability.
In EMSI the buyer argues that the parties took a step beyond Abry in the stock purchase agreement’s exclusive remedy provision, Section 10.10(b), by allowing the buyer, without limitation or restriction, “to recover any amounts in connection with any action or claim ‘based upon fraud’ in connection with the contemplated transaction.”
The buyer in EMSI contends that, in this respect, unlike in Abry, the purchase agreement deliberately “allocated to sellers the risk that the company was knowingly misrepresenting itself when it entered into the SPA.”
The buyer also argues that the claim is not subject to the limitations on recovery imposed by the indemnification cap in Section 10.4(b), since its indemnification claim is “based upon” the allegedly fraudulent misrepresentations in the representations and warranties by the company, as opposed to merely innocent breaches of the purchase agreement.
This is so, the buyer maintains, even if it has not pled and cannot prove that the institutional sellers acted with scienter in connection with their own representations and warranties or knew that the company’s representations and warranties were false when made.
Vice Chancellor Slights found that the EMSI contract construction was complicated by what he believed to be two competing “notwithstanding clauses.”
One is in the exclusive remedy provision, Section 10.10(b), and provides that “[n]otwithstanding anything in this agreement to the contrary (including ... any limitations on remedies or recoveries...) nothing in this agreement (or elsewhere) shall limit or restrict ... any indemnified party’s rights or ability to maintain or recover any amounts in connection with any action or claim based upon fraud in connection with the transactions contemplated hereby.”
The other is in the indemnity cap, Section 10.4(d), which provides that “[n]otwithstanding anything to the contrary in this agreement (including, without limitation, Section 10.2) ... the buyer indemnified parties shall not be entitled to indemnification under Section 10.2(a) for any and all losses ... in excess of ... and exclusively from, any then-remaining escrow funds.”
The buyer argued the specific “notwithstanding” clause in the exclusive remedy provision expressly disclaims all limitations on remedies or recoveries in any action or claim based upon fraud and must prevail over the general “notwithstanding” clause in the indemnity cap, which is included in the preamble clause and not specifically tied to the indemnification limits in the indemnify cap.
Vice Chancellor Slights accepted the buyer’s argument and found that it was reasonable to view the competing “notwithstanding” clauses as conflicting and to interpret the “notwithstanding” clause in the exclusive remedy provision as trumping the “notwithstanding” clause in the indemnity cap.
Whether the parties intended the “notwithstanding” clause in the exclusive remedy provision to go beyond Abry by removing limits on the seller’s liability for “any” claim “based upon fraud,” including claims that the company alone committed fraud in its contractual representations and warranties, cannot be gleaned as a matter of law from the four corners of the purchase agreement.
Therefore, Vice Chancellor Slights denied a motion to dismiss, thereby subjecting the institutional shareholders to further expensive litigation.
The problem with the EMSI decision is that the buyer’s legal argument is not “reasonable.” The EMSI purchase agreement should have been interpreted within the context of established Delaware law and prevailing M&A practice, as clearly described in Abry.
Under Delaware law, the contractual indemnity cap and the exclusive remedy provision in an acquisition agreement cannot prevent a seller from independently pursuing a tort-based claim for rescission or alternatively damages against a seller engaged in fraud in an amount in excess of the indemnity cap.
The “notwithstanding” clause in the exclusive remedy provision, Section 10.10, was limited to “any action or claim based upon fraud.” The reference to “claim” refers to a “claim for fraud.”
In EMSI, as distinguished from Abry, the buyer does not have a claim for fraud against the institutional sellers.
The Abry opinion is replete with references to “claim” as referring to a legal cause of action: “By its terms, the stock purchase agreement makes an indemnity claim the exclusive remedy of the buyer for misrepresentation and bars a rescission claim.”
A claim against the institutional sellers for contractual indemnification for losses resulting from breaches of the company’s representations and warranties is not a tort-based claim for fraud. The complaint fails to state a claim for fraud against the institutional sellers.
Notwithstanding the fact that EMSI may have been wrongly decided, sellers and their counsel need to specifically consider, and if appropriate unambiguously provide that no fraud exception will apply to the cap on an indemnification claim against a seller unless the individual seller consciously knew the representation was false and acted with an illicit state of mind.
1 EMSI Acquisition Inc. v. Contrarian Funds LLC, No. 12648-VCS, 2017 WL 1732369 (Del. Ch. May 3, 2017).
2 Abry Partners V LP v. F&W Acquisition LLC, 891 A.2d 1032, 1064 (Del. Ch. 2006).
3 EMSI Acquisition, 2017 WL 1732369 at *3.
4 Id. at *5.
5 Abry, 891 A.2d at 1064.