A current trend in the M&A market highlights the increasing leverage of private equity firms selling portfolio companies. Purchase and sale agreements in which private equity firms are sellers frequently include indemnification provisions that specifically prohibit certain extra-contractual buyer remedies (such as rescission for fraud or misrepresentation). They often contain very low caps on the seller?s liability for breaches of representations and warranties and short survival periods for representations and warranties. In deals in which private equity buyers are looking to minimize their post-closing exposure to unknown liabilities and private equity sellers are looking to make clean breaks after selling portfolio companies in order to promptly distribute the sale proceeds, both parties may need to look to third parties (such as insurance companies) to achieve these somewhat conflicting objectives.
ABRY PARTNERS V, L.P. V. F&W ACQUISITION LLC
In ABRY Partners V, L.P. v. F&W Acquisition LLC, the Delaware Chancery Court enforced provisions in a stock purchase agreement that severely limited the seller's liability to the buyer for claims arising out of material misrepresentations in the agreement. Three months after closing the $500 million acquisition of F&W Publications, Inc., a magazine publishing business owned by private equity firm Providence Equity, the buyer (a group of entities affiliated with the private equity firm ABRY Partners) sued to rescind the agreement based upon claims of fraudulent inducement and negligent misrepresentation. ABRY alleged that Providence collaborated with F&W in misrepresenting material facts in financial statements and operational conditions of F&W to fraudulently induce ABRY into paying an artificially inflated selling price. The purchase agreement contained three important provisions:
- It contained a ?non-reliance? clause that eliminated any seller liability for the buyer?s reliance upon any representations or information outside of the four corners of the agreement.
- It capped the seller?s liability for indemnification claims to an aggregate of $20 million.
- It provided that claims under the indemnification provisions would serve as the buyer?s exclusive remedy for misrepresentations (barring rescission claims).
In its ruling to enforce the agreement, the court concluded that Delaware law permits sophisticated commercial parties to craft contracts that insulate a seller from a rescission claim for a contractually false statement of fact that is not intentionally made.
The ABRY decision does not suggest that parties can insulate themselves from liability if a buyer can prove the seller's fraud. The court specifically noted that where a buyer is able to demonstrate either that the seller knew that the contractual representations of the company being sold were false or that the seller itself intentionally lied to the buyer about such representations, an exclusive remedy provision could not insulate the seller against fraud claims under such circumstances. One distinction that influenced the court was that the allegedly fraudulent statements were made by F&W and not by Providence, and ABRY could not demonstrate to the court that Providence knew about the fraudulent nature of F&W's representations. The court further noted that a buyer asking for rescission when alleging fraud on the part of a seller must prove that the seller acted with an illicit state of mind, meaning that the seller knew that the representation was false and either communicated it to the buyer directly itself or knew that [the portfolio company] had.
ALTERNATIVE MEANS OF PROTECTING BUYERS
Given the increasing negotiating power of sellers with respect to indemnification provisions, buyers may want to consider looking to insurers to help reduce the risk of unknown liabilities that may arise after the closing of an acquisition. They may wish to look to representations and warranties insurance (RWI) policies, which can reduce their exposure to the unpredictability of post-closing losses. RWI has several straightforward and practical benefits. First, buyers can purchase it for their benefit when a seller is only willing to accept very low caps on its indemnification obligations or short survival periods for the representations and warranties, or when the seller refuses to provide an escrow to support indemnity claims. RWI can also reduce the amount of time and energy the parties spend negotiating the terms of the seller's indemnification obligations. Additionally, the buyer may be able to procure RWI for periods that exceed the agreed upon survival of the representations and warranties in the purchase agreement. This could be particularly valuable with respect to liabilities that may surface after closing, such as environmental hazards or title issues.
Lastly, enlisting an insurance company as a neutral third party to distribute funds according to liability may be more desirable than using an escrow fund, which generally requires consent from the seller to pay indemnification claims.