EMSI Acquisition, Inc. v. Contrarian Funds, LLC, et al., C.A. No. 12468-VCS (Del. Ch. May 3, 2017), Slights, V.C. The Delaware Court of Chancery honored the well-settled policy against fraud and its limitation on parties’ freedom of contract in the context of allocating risk in a stock purchase agreement. While parties are free to shift risk and/or limit their liability arising out of a sale, the Delaware courts “will not permit a party to a contract to disclaim or eliminate a claim that it made ‘a knowingly false contractual representation.’”

This case concerned a purchaser’s post-closing claims for indemnification arising out of the sale of EMSI Holding Company. The defendants sought to sell their equity in the company, and as part of their marketing efforts, prepared a memorandum which included financial projections. These projections reflected a positive future despite historical trends that showed a decline in the company’s profitability. Plaintiff EMSI Acquisition, Inc. and the defendants entered into negotiations for the purchase of the defendants’ equity interest. The defendants supplied the plaintiff additional financial projections that revealed “significant near-term growth potential.” The plaintiff purportedly used these financial projections to calculate the purchase price.

The parties entered into a stock purchase agreement (the “SPA”) for the sale of the defendants’ equity in the company. Article II of the SPA set forth a post-closing adjustment procedure that included “[a] Settlement Auditor,” in which any price adjustment was required to be paid out of the $9.56 million held in an escrow fund (the “Escrow Amount”). To the extent that the price adjustment exceeded the Escrow Amount, the SPA provided that the seller would not be liable for any deficiency. Articles III and IV of the SPA included representations of the company and the sellers. The SPA included specific language that disclaimed any representations or warranties not set forth in the SPA. Similarly, the buyer represented that it relied only on those promises or representations contained in the SPA. Article X outlined the parties’ indemnification obligations. Section 10.2 obligated the seller to indemnify and hold harmless the buyer from any losses arising out of a breach of any warranty, covenant or representation of the SPA. Section 10.4 limited this indemnity obligation: “Notwithstanding anything to the contrary in this Agreement (including without limitation, Section 10.2) … [the buyer] 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 … exceed $450,000 (the ‘Basket Amount’), in which event, subject to the terms of this Article X and the Escrow Agreement, [the buyer] will be entitled to indemnification … in excess of the asset Amount to the extent of, an exclusively from, any then remaining Escrow Funds.” Section 10.4 further limited the seller’s indemnity obligation: “Notwithstanding anything contrary in this Agreement … to the extent of, and exclusively from, any then-remaining Escrow Funds … .” Section 10.10 stated that while the buyer’s exclusive remedy for a seller’s breach of a warranty, covenant or representation was indemnification, “nothing in this Agreement … shall limit or restrict (i) any [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 … .”

After the sale closed, the plaintiff obtained a forensic investigation in light of the company’s poor performance. The investigation uncovered a manipulation of the company’s financial models and the creation of fake files by the company’s employees to facilitate the sale. The plaintiff initiated a formal dispute resolution process with an auditor. The auditor agreed with the plaintiff’s position that as a result of the inaccurate financial data, the defendants owed the plaintiffs $9.89 million, which exceeded the $9.56 million held in escrow.

The plaintiff commenced suit in the Delaware Court of Chancery to confirm the findings of the auditor as an award under the Delaware Arbitration Act and recover the $9.89 million in damages (the “Complaint”). The defendants moved to dismiss the complaint on three grounds: (1) the plaintiff’s recovery may not exceed the Escrow Amount, (2) the Complaint fails to plead fraud with particularity and (3) the auditor was not authorized to make a binding determination.

The Court rejected the defendants’ argument to dismiss the Complaint based on those provisions in the SPA that limited the plaintiff’s recovery to the Escrow Amount. Delaware law permits “[p]arties [to] shift risks of loss in their indemnification schemes as is appropriate and necessary to get the deal done, and can disclaim certain claims and remedies as well.” However, “‘Delaware’s strong public policy against intentional fraud’ will not permit a party to a contract to disclaim or eliminate a claim that it made a ‘knowingly false contractual representation.’” In light of its seminal opinion in Abry Partners V, L.P. v. F&W Acquisition LLC, the Court noted that “absent a contract portal, the Plaintiff (Buyer) cannot reach the Defendants (Sellers) on an indemnification claim beyond the bargained-for limits (the Escrow Funds) unless Plaintiff can demonstrate that Defendants acted with an ‘illicit state of mind’ or ‘knew that the [c]ompany’s representations and warranties were false.’”

The defendants’ argument turned on construction of Article X of the SPA, which the Court found to be susceptible to two reasonable interpretations, thereby warranting denial of the motion. “Contract construction, in this instance, is complicated by two competing ‘notwithstanding clauses’” — one in Section 10.4 and the other in 10.10. “[A] ‘notwithstanding’ clause clearly signals the drafter’s intention that the provisions of the ‘notwithstanding’ section override conflicting provisions of any other section.” This general rule “is less useful when the contract contains two apparently conflicting ‘notwithstanding’ clauses, both of which, at first glance, appear to ‘override’ the other.” The defendants attempted to reconcile this conflict by arguing that Sections 10.2 and 10.4 capped their liability for claims of fraud and Section 10.10 limited the effectiveness of this cap only to the extent that the alleged fraud concerned extra-contractual representations and warranties. The Court found that the defendants’ argument was a reasonable construction of the SPA; however, “it [was] not the only reasonable construction allowed by these provisions.” Section 10.10 includes “very broad language” which failed to distinguish between contractual and extra-contractual claims for fraud, in which case, it would be reasonable to read Article X “to reflect that the parties agreed that there would be no limitations on recovery from the Sellers for any action or claim based on fraud.” Upon finding that Article X was susceptible to two reasonable interpretations, the Court was unable to dispose of the plaintiff’s claims at this initial stage in the case.

The Court also rejected the defendants’ argument to dismiss the Complaint based on the plaintiff’s purported failure to plead fraud with particularity. Where a plaintiff’s allegations of fraud “appear in a contract, the pleading burden is easily satisfied for elements other than knowledge … .” The defendants argued that the plaintiff pleaded no more than simple acts committed by low-level employees to engage in fraudulent accounting, and they asked the Court “to take guidance from federal securities fraud cases … [to] impose a ‘stringent rule for inferences involving scienter.’” The Court not only declined the defendants’ invitation but also found that the plaintiff adequately alleged the defendants’ knowledge of the fraud through principles of agency law.

While the Court found that Count I of the Complaint survived dismissal for the reasons set forth above, it granted the defendants’ motion as to the plaintiff’s request to confirm the findings of the auditor pursuant to the Delaware Arbitration Act. The Court found that the auditor’s decision was not an arbitration award that could be confirmed without dishonoring the parties’ bargained-for rights. The SPA provided that “the Settlement Auditor will resolve disputes … ‘acting as an expert and not an arbitrator.’” While there are instances where the decision of an expert in a dispute resolution proceeding could amount to an arbitration award, such result is not permissible in this case because “the contract language on point expressly states that the auditor/expert is not acting as an arbitrator.” Adhering to the unambiguous, plain language meaning of the SPA, the Court determined that the decision of the auditor could not be confirmed under the Delaware Arbitration Act and dismissed Count II of the Complaint.

This opinion is noteworthy in light of the Court’s recognition of certain exceptions to the widely accepted practice of honoring the allocation of risk agreed to between contracting parties, particularly in the case of fraud. Delaware case law is replete with case examples of courts construing the unambiguous language of an agreement to give effect to the parties’ intent. Where the contractual language is ambiguous, a court may consider extrinsic evidence. In this instance, the parties attempted to allocate risk arising out of the transaction in light of the Court’s decision in Abry Partners V, L.P. The Court found that the risk allocation provision was susceptible to more than one reasonable interpretation and accordingly denied the motion to dismiss the plaintiff’s allegations of fraud.