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Monday, May 29, 2006

Can You Disclaim the Obligation to be Truthful?

Jeff_lipshaw_1 When sophisticated parties, represented by able counsel, agree to a contract term that explicitly releases either party from liability for misrepresentation and disclaims all reliance in a complex transaction, should courts nevertheless protect the party when it later claims foul?

In a recent decision, Abry Partners V, L.P. v. F&W Acquisition, LLC, the Delaware Court of Chancery said "no," although rather cautiously.  The case involved a transaction selling a "portfolio company" from one "sophisticated private equity firm" to another.  According to the court, the contract

carefully delineated the representations and warranties that were being made by the portfolio Company that was being sold and by the owner of that Company. By its plain and unambiguous terms, the Stock Purchase Agreement stated the Buyer’s promise that it was not relying upon representations and warranties not contained within the Agreement’s four corners and that no such extra-contractual representations had been made.

More critically for purposes of this case, the Stock Purchase Agreement went further. By its terms, it purports to limit the liability of the Seller for any misrepresentation of fact contained within the Agreement to exposure for a claim for damages in arbitration (an “Indemnity Claim”) not to exceed the amount of a contractually-established Indemnity Fund. That fund is set at $20 million, or 4% of the $500 million purchase price paid by the Buyer for the portfolio company. By its terms, the Stock Purchase Agreement makes an Indemnity Claim the exclusive remedy of the Buyer for misrepresentation and bars a rescission claim of the nature the Buyer has pled in this court.

The court nevertheless held, as a matter of public policy, that a claim for misrepresentation could go forward and that the indemnity agreement did not cap the damages.

In a new paper, Of Fine Lines, Blunt Instruments, and Predictability: The Right to Lie in Business Acquisition Agreements, Tulane's Jeffrey M. Lipshaw argues that the court's conclusion was correct, though its reasoning was wrong.  Here's the abstract:

The Delaware Court of Chancery recently attempted to navigate the law of contract and fraud, where the buyer in a complex business acquisition alleged that the seller intentionally misrepresented the financial condition of the target company. This is a brief reaction to some immediate academic criticism of the opinion, which struggled over the extent to which the court should enforce the buyer's contractual disclaimer of reliance, and whether the limited exclusive contract remedy barred rescission based on fraud.

I think the case raises fundamental theoretical issues about a subtle truth-telling understanding among those who negotiate complex deals, and whether the power of language can be harnessed to reflect it. While the court permitted a fraud claim based on knowingly false contract representations to survive a motion to dismiss for failure to state a claim, both the court's opinion and the academic criticism reflect an excess of contract formalism and an over-concern for efficiency. The resulting law does not track the common understanding of participants in complex acquisitions, nor more generally how we ordinarily expect language to be used.

Courts should presume that the parties are aware of the law of fraud in all of its complexity (including omissions and half-truths) and permit only the narrowest interpretation of an attempt to avoid it. Hence, we would leave the cause of action in fraud, both for matters within and without the contract, intact, except insofar as the parties have explicitly disclaimed it. This is, in the end, I suspect a broader remedy than rational actor theorists or contract formalists might want, but one that I think more accurately maps on the fine line of the understanding among the lawyers and clients in the hothouse atmosphere of an intense merger or acquisition negotiation. I propose several theoretical reasons for the conclusion.

[Frank Snyder]

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