Further Guidance from the Delaware Court of Chancery on Fraud in the M&A Context

In its August 12, 2021 ruling on a motion to dismiss in Online HealthNow, Inc. v. CIP OCL Invs., LLC, the Delaware Court of Chancery answered some of the previously open questions regarding fraud in the M&A context, specifically when a plaintiff can bring a contractual fraud claim and against whom those claims can be brought.

The seminal case, ABRY Partners V, L.P. v. F&W Acquisition LLC, decided by the Delaware Court of Chancery in 2006, established that:

  1. Provisions limiting a buyer’s ability to bring claims for fraud based on statements made outside the contract (i.e. extra-contractual fraud claims) are enforceable.
  2. Provisions limiting a buyer’s ability to bring claims for fraud based on statements made within the contract (i.e. contractual fraud claims) are not enforceable.
  3. Caps on damages for contractual fraud claims are not enforceable.

In Online HealthNow, the Delaware Court of Chancery expanded on ABRY and held that (1) survival provisions purporting to limit the timeframe during which contractual fraud claims may be brought will not be enforced, and (2) non-recourse provisions purporting to limit liability for contractual fraud to only the parties to the agreement will not be enforced if other parties were active and knowing participants in such fraud.

The plaintiff in this case, Bertelsmann, Inc. (the “Buyer”) entered into a stock purchase agreement (the “SPA”) to acquire all of the outstanding shares of CIP OCL Holdings, Inc. (the “Company”) from CIP OCL Investments, LLC (the “Seller”). The Seller was directly owned, in part, and controlled by CIP Capital, a private equity fund (the “PE Fund”).

The Misrepresentation

A representative of the PE Fund allegedly directed the Chief Financial Officer of OnCourse Learning Corporation (“OCL”), one of the target subsidiaries, to provide bidders with skewed financials to support an inflated earnings forecast. OCL had not been using its tax reporting software properly, which meant that it was not properly collecting, or remitting, sales and use taxes. The PE Fund and OCL allegedly knew this to be the case and provided different information to different bidders. One bidder, to whom the liability was actually disclosed, would have required a one-year escrow of at least $15 million, or a reduction in the purchase price.

The SPA Provisions

As is customary, the Seller made certain representations and warranties in the SPA to the effect that (1) all tax returns had been duly and timely filed and were true, complete and accurate in all material respects; (2) the Company had no undisclosed liabilities; and (3) there had been no material changes to the Company’s accounting policies or practices with respect to collections of accounts receivable.

The SPA contained two other critical provisions: (1) a survival clause, stating that all representations and warranties in the SPA terminated at closing, and therefore there could be no post-closing liability (the “Survival Clause”); and (2) a non-recourse provision, stating that the SPA could only be enforced against the parties to the SPA (the “Non-Recourse Provision”).

The Claims

The Buyer filed suit against the Seller, the PE Fund, and individuals from both the PE Fund and OCL, alleging, among other counts, that such parties fraudulently induced the Buyer to enter into the transaction by making false representations in the SPA. The defendants moved to dismiss, arguing that the SPA itself specifically precluded the claims, through the Survival Clause and Non-Recourse Provision.

The Survival Clause

The defendants distinguished ABRY by arguing that survival clauses are not a limitation on remedy, as struck down in ABRY in the fraud context, but rather a limit on the time period to pursue that remedy. Defendants cited another Delaware case, Sterling Network Exchange, LLC v. Digital Phoenix Van Buren, LLC, which held that the parties may agree to shorten the limitations period for fraud claims, if there is a reasonable opportunity to discover any potential misrepresentations.  In other words, Sterling left open the possibility that a survival clause could still preclude a contractual fraud claim under the right circumstances.

The Court here expressed skepticism that Sterling was an accurate representation of Delaware law, and held that the Survival Clause would not be enforced to preclude a claim that the contract itself was an instrument of fraud.

The Non-Recourse Provision

The defendants also argued that even if the claims were not barred altogether, the Non-Recourse provision precluded any claims against the PE Fund and the individual defendants because they were not parties to the SPA. The Buyer argued that those defendants could not invoke the Non-Recourse Provision if they knowingly participated in the alleged contractual fraud. The court agreed and found that because those defendants were alleged to have knowingly facilitated the fraudulent misrepresentation through their participation in the working group for the transaction, they could not use the Non-Recourse Provision as a shield.

Practical Implications

The Online HealthNow and ABRY decisions have made it clear that Delaware courts will not allow buyers and sellers to contractually limit in any way their liability with respect to fraudulent statements made in purchase agreements.  On the other hand, the decisions have also made it clear that parties to a contract can contractually disclaim reliance on any and all statements made outside the contract, regardless of whether such extra-contractual statements are true.  A seller should focus on making sure that all representations and warranties set forth in an acquisition agreement are true and accurate, while at the same time making sure that (1) the buyer expressly disclaims reliance on any statements that are not expressly set forth in the acquisition agreement, and (2) the acquisition agreement expressly prohibits a buyer from bringing any claims against a seller or any other person for any statements that are not expressly set forth in the acquisition agreement.

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