The Delaware Supreme Court, sitting en banc, unanimously held that a trial court committed reversible error by instructing a jury that a seller of a business could be liable for fraud through recklessness when the purchase agreement expressly limited such claims to intentional fraud only.
By its decision, the Delaware Supreme Court affirmed the public policy balance struck 15 years ago in the Delaware Chancery Court's seminal decision in the ABRY Partners1 case, which held that, as a matter of public policy, a contract party cannot limit its liability for intentional fraud, but contractual liability limitations attributable to lesser states of mind, such as recklessness or gross negligence, are permissible.
In Express Scripts, Inc. v. Bracket Holdings Corp. (February 23, 2021)2, a limited liability company seller sold the stock of three subsidiaries (collectively, the "Company") to a private equity-sponsored acquisition vehicle. The securities purchase agreement provided that other than claims for "deliberate" fraud and breaches of fundamental representations, the buyer's sole and exclusive remedy with respect to any claims for breaches of representations and warranties were to be satisfied by the representations and warranties insurance policy that was put in place at the closing of the transaction.
After closing, the buyer asserted that the seller and its parent company engaged in fraud by making non-fundamental representations regarding financial statements that contained inflated historical revenue and overstated unbilled receivables. The buyer asserted a claim under the insurance policy and through arbitration successfully recovered a portion of the amount it alleged that it lost by overpaying for the Company. The buyer then brought a suit in Delaware Superior Court against the seller and related parties for fraudulently inducing the buyer to purchase the Company. After a trial, a jury found the seller parties liable and awarded damages to the buyer.
On appeal, the issue before the Court was whether the trial court had erred by instructing the jury that the state of mind requirement necessary to sustain a claim of fraud could be satisfied if the buyer established that the seller knew the representations in question were false or acted with reckless indifference as to whether such representations were false.
The Court began its analysis by acknowledging the balance that the court in ABRY Partners struck to address the tension between the two strong competing interests of not permitting contracts to insulate a contracting party from its own fraudulent conduct, on the one hand, and Delaware's tradition of freedom of contract and emphasis on efficient commercial law. To that end, the ABRY Partners court ruled that it was against public policy for a contracting party to be able to limit its liability for its own intentional fraud, but the contracting parties could agree to limit the liability for actions involving lesser states of mind, such as recklessness and gross negligence. The Court stated that the purchase agreement reflected an adoption of the balanced approach set forth in ABRY Partners by providing that the seller would only be liable for its intentional fraud, but the seller would not be liable for its reckless fraud. Unless the buyer could establish intentional fraud, the sole recourse for the buyer was to pursue a claim under the representations and warranties insurance policy. Note that although the purchase agreement used the phrase "deliberate fraud," the court concluded that had the same meaning as "intentional fraud," the standard used in Delaware law.
The Court held that the trial court committed reversible error when it instructed the jury that the seller parties could be liable for fraud if they acted recklessly and remanded the case for a new trial.
Observations and Practice Points
- State of Mind for Fraud
Claims. In its decision, the Delaware Supreme Court
adopted the rule established in ABRY Partners, permitting
sellers to contractually eliminate all potential claims against
them except for claims involving intentional fraud. The holding is
significant because to establish the required state of mind for a
fraud claim under Delaware law, a defendant must have known or
believed that a representation was false or made the representation
with reckless indifference to the truth. By permitting contract
parties to agree to limit fraud claims to only those involving
intentional fraud, claims for fraud from defendant's
recklessness and claims attributable to other states of mind can be
eliminated (and the risk shifted to the buyer if the seller should,
in effect, make a representation with inadequate deliberation or
- Fraud Carve-Outs.
The Court also agreed with the flip side of ABRY Partners,
adopting the position that a seller could not by agreement
eliminate the buyer's ability to bring a claim for intentional
fraud. As Delaware courts will not permit, as a matter of public
policy, a seller to escape liability for its intentional fraud,
even a purchase agreement that provides that a buyer had no
post-closing recourse against the seller for breaches of
representations and warranties would not foreclose a buyer's
claim for intentional fraud. Notwithstanding that a carve-out for
claims of intentional fraud is not necessary in a purchase
agreement, since the ABRY Partners decision buyers have
typically insisted on having a fraud carve-out in the purchase
agreement. As deal lawyers began negotiating fraud carve-outs in
such agreements, the specific language of such carve-outs evidenced
a varied practice. The holding of this case illustrates the
importance of negotiating appropriate fraud carve-outs in purchase
agreements. A seller, by requiring a carve-out for only
"intentional fraud," will be potentially limiting its
post-closing exposure more than if the carve-out is for
"fraud," "actual fraud" or "common law
fraud" or similar terms encompassing more than intentional
fraud, and will not be exposing itself to any more liability than
it would face if there were no carve-out at all.
- No Indemnity Deals.
The circumstances the buyer faced in this case are becoming more
common in private M&A transactions. With the high demand for
quality M&A targets, due in no small part to the number and
size of private equity funds seeking investments, sellers have
increasingly gained negotiating leverage to extract the best
possible terms from buyers, particularly in auction transactions.
While indemnity terms have been trending strongly in favor of
sellers since the rise of private equity funds, recently many
sellers have proposed initial drafts of purchase agreements that
are "no indemnity" deals. In effect, a no indemnity
deal provides that the representations and warranties expire at the
closing of the transaction, and the buyer has no claim against the
seller for breaches of representations and warranties. The buyer
often negotiates for the seller to be liable for breaches of
fundamental representations and for fraud, but otherwise agrees to
have its representations and warranties insurance policy be its
exclusive remedy for breaches of representations and warranties.
Such deals, however, under Delaware's public policy exception,
would not eliminate seller's liability for intentional fraud in
connection with contractual representations and warranties.
- The Rise in Fraud
Claims. Once the representations and warranties insurance
policy limits are exhausted, buyers are increasingly bringing fraud
claims against sellers to seek to recover the remaining alleged
damages because fraud claims are the only remaining claims
permitted under the typical purchase agreement. Often, the
insurance policy will have a coverage cap of 10 percent of the
purchase price, which represents the typical level of the purchase
agreement indemnification cap for breaches of representations and
warranties that was prevalent at the time that such insurance
policies began to be used with frequency. When a buyer makes a
claim for breaches of certain representations and warranties, such
as the financial statements or customers representations, the
alleged damages can easily exceed the insurance policy cap because
the buyer typically alleges that its damages are equal to the
difference between the price it paid based on a multiple of the
target's earnings and the lower price implied by that same
multiple applied to the reduced earnings of the target that
resulted from the breach of the representation. Claims based on
multiples of earnings can exhaust the available coverage under
insurance policies, resulting in buyers looking to other potential
available remedies to recoup their losses.
Considerations. Claims for intentional fraud, however, may
not result in an effective remedy for buyers. Establishing intent
against the seller for intentional breaches of representations by
the target company may prove difficult. Consider, for example,
intentional fraud by the CFO of the target company in a breach of
the financial statement representation that resulted in the buyer
overpaying. The seller received the excess purchase price, but
(unless otherwise provided in the purchase agreement) that may not
be recoverable by the buyer unless the seller also committed
1. ABRY Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006).
2. https://courts.delaware.gov/Opinions/Download.aspx?id=317280. The Court's decision also addressed an issue relating to the admissibility of certain evidence at trial, which is not the subject of this Legal Update.
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