Crucial to any private equity seller is certainty: the certainty that a sale will be consummated at an agreed price and that any potential post-closing liability is fully understood in advance of distributing proceeds to limited partners. The recent Delaware decision, EMSI Acquisition Inc. v. Contrarian Funds LLC, C.A. No. 12648-VCS (Del. Ch. May 3, 2017) underscores how an imprecisely drafted fraud carve-out can strip private equity sellers of this certainty and open the door to long, costly and unpredictable legal battles.

Fraud carve-outs under Delaware law are understood within the framework of the seminal decision of Abry Partners V, L.P. v. F&W Acquisition LLC 891 A.2d 1032 (Del. Ch. 2006): fraud claims based on extra-contractual representations and warranties (“R&Ws”) can be precluded if the buyer expressly disclaims reliance upon any extra-contractual statements, but common law fraud claims based on contractual R&Ws cannot be precluded or even confined to a negotiated cap because, as a matter of public policy, the available remedies for fraudulent contractual R&W’s cannot be contractually limited where a seller knows that the target company’s contractual R&Ws are false or where a seller itself lies to a buyer about such R&Ws.

In the EMSI case, the buyer made a post-closing indemnification claim against the sellers, most of whom were former institutional investors in EMSI (who had neither managerial oversight nor a participatory role in the preparation of financial information used in making R&Ws in the purchase agreement), for allegedly fraudulent R&Ws in the purchase agreement regarding EMSI’s financial position. These R&Ws were made by the target company, not the investors themselves who were selling their stakes in EMSI, but under the indemnification provision, the sellers agreed to indemnify the buyer for breaches of R&Ws made by the target company. With the cap on post-closing indemnification claims by the buyer against the sellers already reached, the buyer commenced an action in the Delaware Chancery Court, arguing that the fraud carve-out to the liability cap made the sellers, including all institutional sellers, liable for uncapped damages for fraud.

The sellers argued that, although the buyer could make a claim based on a breach of the target company's R&Ws, the buyer could not make a claim for uncapped damages, as such a claim was not contemplated by the indemnification provisions of the purchase agreement. The sellers rooted their argument in a provision of the purchase agreement that stated that:

[n]otwithstanding anything to the contrary in this Agreement (including, without limitation, Section 10.2 [Indemnification])…: (b) The Buyer Indemnified Parties shall not be entitled to indemnification under Section 10.2(a) for any and all Losses… in excess of… any then-remaining Escrow Funds.

The buyer, on the other hand, argued that since the sellers stood behind the target company’s R&Ws, the undefined “fraud” carve-out in the contract meant that a fraudulent breach of those R&Ws exposed the sellers to uncapped liability for any and all losses suffered by the buyer, directing the court to the following broad and undefined fraud carve-out:

[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 (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 parties each stressed a different interpretation of the non-reliance provisions, fraud carve-outs related thereto and cap on liability. The buyer asserted that the contract went further than Delaware’s public policy necessitated by creating a category of claims “based upon fraud” so, although the alleged fraud was the target company’s and the sellers themselves may have been unaware of the fraudulent misrepresentation, the broad carve-out enabled the buyer to make an indemnification claim against the sellers that was based on the target company’s alleged fraud. The sellers maintained that the liability cap, which had already been met, precluded the buyer from recovery of any additional damages, and the buyer asserted that such cap should not be applied since the purchase agreement expressly permitted uncapped claims for any action or claim based upon fraud. Had the fraud carve-out been more narrowly tailored, and precisely drafted, so as to limit exposure as much as allowed under the Abry framework, the buyer would have needed to show that the sellers knew that the target company’s contractual R&Ws were false to claim uncapped remedies.

The Court of Chancery was tasked with settling a dispute over ambiguous drafting and dueling provisions. It faced competing “notwithstanding” clauses and two reasonable readings of the contract, so Vice Chancellor Slights ordered the case to proceed to trial, finding extrinsic evidence discoverable through trial to be necessary to determine which provision should prevail. This outcome, which will likely involve a drawn-out and expensive process, is already a loss for the sellers.

A clear takeaway from EMSI is the importance of clear and cohesive drafting, particularly with respect to fraud and indemnification. Sellers will typically desire to limit the opportunities for a buyer to bring claims of fraud and buyers will often seek to use fraud carve-outs to preserve flexibility to bring uncapped claims. Clear definitions of fraud as well as unambiguous non-reliance provisions minimize the likelihood of unexpected liability for both parties, but in particular, should help a private equity seller to achieve its goals of certainty with respect to its ability to distribute sale proceeds after it consummates a transaction.