Sophisticated buyers and sellers of businesses carefully devote extensive attention to negotiating and structuring numerous important “deal points” in merger agreements, asset purchase agreements, and stock purchase agreements (“M&A agreement(s)”). Although the decision as to which state’s law will govern the M&A agreement is often one of the last (and sometimes lightly regarded) deal points addressed by the parties, ironically, this seemingly simple provision can ultimately upset some of the more painstakingly negotiated deal points elsewhere in the M&A agreement. The North Carolina Business Court’s recent opinion in KLATMW, Inc. v. Electronic Systems Protection, Inc., 2011 NCBC 12, highlights the significance of the choice of law determination in deals and serves as a helpful reminder of the subtle and complex interrelationships among all of the various provisions typically found in M&A agreements.
In KLATMW, a lawsuit arose after the closing of a sale of assets of an ongoing business operating in North Carolina. The asset purchase agreement provided that any lawsuits arising in connection with the agreement should be governed by New York law. The sellers, Nevada corporations, filed suit to obtain the release of purchase price funds that had been escrowed; the buyer, a Delaware corporation formed to acquire the assets, asserted multiple counterclaims alleging that the sellers breached certain warranties under the asset purchase agreement, and also asserting tort claims and North Carolina statutory claims. The sellers contended that even if any warranty was breached, the buyer learned about the breach prior to closing (as a result of certain disclosures made by the sellers), but the buyer still closed the transaction. As noted, the asset purchase agreement called for New York law to govern. The North Carolina Business Court, therefore, determined that New York law controlled all claims and pointed out that the parties’ choice of law had a “significant” impact on the warranty and statutory claims. The court reasoned that the critical issue regarding the buyer’s breach of warranty counterclaims was whether the buyer learned of the breach from the sellers’ disclosures before closing and nevertheless closed the deal – thus somehow waiving its right to recover damages for breach of warranty. As discussed by the Business Court, under New York law, a buyer may waive its right to recover on a breach of warranty claim under an M&A agreement if the buyer “receives information from its seller that the warranty is breached but closes the sale with full knowledge and acceptance of that breach,” unless the buyer expressly preserves its rights to recover on the claim. Ruling on cross-motions for summary judgment, the Business Court determined that there were disputed issues of material fact about whether the buyer waived the breach of certain warranties and that the case should proceed to resolve those (and other) issues.
The practice of a buyer preserving and pursuing a post-closing claim for breach of a seller’s representations and warranties contained in an M&A agreement, where the buyer knew or suspected pre-closing that those representations or warranties were false, is often pejoratively referred to as “sandbagging.” This issue is sometimes addressed in the negotiation of the M&A agreement. M&A agreements can include “pro-sandbagging” provisions, which expressly state that the seller’s representations and warranties are not waived by the buyer’s pre-closing knowledge that any particular representation or warranty might be untrue. On the other hand, M&A agreements can include “anti-sandbagging” provisions under which a buyer waives any claims if the buyer knew of a pre-closing breach. Many M&A agreements, however, are silent on the issue of sandbagging, thus sometimes making the choice of law decision critical to the issue. Based on the Business Court’s opinion in KLATMW, it appears that this particular asset purchase agreement was likely silent as to sandbagging – which is not unusual, especially when the parties are unable to agree on how to treat this rather sensitive subject.
In the KLATMW deal, a Delaware corporation bought North Carolina-based assets from Nevada corporations. Although the Business Court’s opinion does not provide notable insight into the underlying negotiations, one can conceive of buyers and sellers in similar transactions reasonably advocating for Delaware, North Carolina, or Nevada law as the controlling law for the M&A agreement. The parties to the KLATMW transaction chose New York law. With regard to the sandbagging issue, it is possible that a court may reach a different result by applying Delaware law because certain Delaware decisions, as compared to New York cases, have been more lenient in allowing a buyer to sandbag unless the M&A agreement includes an express anti-sandbagging provision. Likewise, if the parties chose North Carolina law, application of North Carolina law may possibly yield another outcome because North Carolina courts have not yet ruled on this specific issue. While the KLATMW court did not provide explicit guidance about what the North Carolina standard will be, and the case still must be resolved on the factual dispute, the court suggested the possibility of a standard different from both New York and Delaware, commenting that the “New York standard is arguably harshly restrictive in that it limits relevant evidence to facts known to the buyer solely by disclosures made by the seller.”
The KLATMW case also reminds us that certain claims may be precluded by application of an M&A agreement’s choice of law provision. In KLATMW, the Business Court determined that the choice of New York law barred the buyer’s statutory claims asserted under Chapter 75 of the North Carolina General Statutes. While the Business Court stated that extensive contractual remedies provided for in the KLATMW asset purchase agreement would also have justified dismissal of the Chapter 75 claim if North Carolina law applied, situations may arise where certain claims are precluded solely by the choice of law clause.
Importantly, in addition to affecting what claims may be asserted by a dissatisfied buyer or seller and what standard may be applied to those claims, a choice of law clause can also control other significant deal points typically negotiated in M&A agreements. Provisions concerning such key matters as time limitations to assert claims, dispute resolution procedures, indemnification, noncompetition, limitations on liability, and remedies may hinge on the particular state law that governs the agreement. For example, many M&A agreements are stringently drafted in an attempt to define the scope of potential liability and to limit the parties’ remedies to those remedies set forth in the agreement. While certain Delaware cases have held that an exclusive remedy provision may not be categorically enforced, such as when the seller knew certain warranties were false or when the seller lied about representations or warranties, Delaware grants parties substantial discretionary power to limit liability in M&A agreements. Other states’ laws may be far less willing than Delaware to enforce negotiated limitations on liability. As a result, choice of law, rather than the specific contractual language, may be the ultimate determinant of an exclusive remedy provision.
Cases like KLATMW not only serve as reminders of the importance of precise contractual drafting and carefully incorporating due diligence findings into M&A agreements, but also demonstrate that the choice of law provision may unexpectedly impact expectations arising in connection with even the most meticulously prepared agreements. While each M&A negotiation is unique, and there were likely a number of factors and sound business and legal reasoning that resulted in the particular terms and conditions of the KLATMW asset purchase agreement (insight into which we are not privy), it is our observation that in many negotiations the choice of law deal point is discussed by buyers and sellers after many other deal points have been hotly negotiated and methodically drafted – and, the decision as to the controlling law sometimes even results from last minute “horse trading” between the buyer and the seller; without either party fully appreciating the potentially comprehensive impact of that decision. The Business Court’s analysis in KLATMW highlights the importance of buyers and sellers understanding how each provision in an M&A agreement interrelates, and reminds us all that the choice of law decision can sometimes surprisingly supersede careful drafting and the parties’ expectations.