Tuesday, September 11, 2007
Robert Miller over at Truth on the Market has an excellent post up on the recent Second Circuit decision in Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc. The case revolves around the sale by Merrill Lynch of its energy trading business to Allegheny. As Prof. Miller describes it:
After the deal closed, Allegheny discovered that some of the key financial information Merrill provided in due diligence was false. The facts get very complicated at this point, in part because the Merrill employee running the GEM business prior to the transaction had embezzled millions of dollars from Merrill (he’s now in jail) and in part because of disputes about accounting methodologies used in preparing the information. The parties disagree about exactly which statements in the information Merrill produced in due diligence were false, why they were false, and what various of Merrill employees knew or should have known about their falsity at the time the agreement was signed.
Because of these problems, Allegheny subsequently failed to honor a put right in the agreement and make a $115 million payment to Merrill. Merrill sued to compel this payment and Allegheny counter-claimed for fraudulent inducement and breach of the representations in the agreement. The lower court dismissed Allegheny's counter-claims after a bench-trial, but the Second Circuit reversed. I refer you to Prof. Miller's cogent analysis for the reasons why -- but basically the opinion was a straightforward application of New York law on the issues of fraudulent inducement and breach.
The interesting thing is the following representation in the purchase agreement by Merrill warranting that the information provided by Merrill to Allegheny was “in the aggregate, in [Merrill’s] reasonable judgment exercised in good faith, is appropriate for [Allegheny] to evaluate [GEM’s] trading positions and trading operations.” As Prof. Miller notes this representation:
should take the breadth away from any practicing . . . . Merrill is representing that the information it provided was “appropriate” for Allegheny’s evaluating the business. At the very least, this means that Merrill is warranting that it reasonably believed that it delivered all the information that Allegheny needed to value the business. Hence, omissions from due diligence will become actionable. If Merrill had any information it did not produce to Allegheny in due diligence, Allegheny will now argue that such information was reasonably necessary for it to value the business and so its non-delivery to Allegheny was a breach.
By agreeing to this warranty Merrill was essentially placing a high burden on itself to justify any omissions from due diligence in the case of any disputes. The representation can also be reasonably interpreted as warranting the truth of Merrill's due diligence materials, an unbelievably wide-reaching representation. The provision is very unusual, and it is likely that Merrill agreed to it knowing this fact due to potential abnormal problems in the due diligence process prior to signing. Nonetheless, as Prof Miller again observes, given its scope it is unlikely Merrill was fully advised by their lawyers of the ramifications of this representation, who themselves may not have realized what they were agreeing to. Although a charitable view is that Merrill fully knew what it was doing but agreed to this bargain based on its limited liability under the indemnification provisions. Pure speculation since I have not seen the actual purchase agreement.
Ultimately, one of the things this dispute and particular representation highlight is the caution M&A lawyers must have in drafting representations. I was often shocked in private practice to find that M&A lawyers in both the big shops and otherwise often didn't have a full grasp of the scope and ramifications of representations instead preferring to over-rely on the "form". When they strayed they often agreed to overly broad or vague representations without appreciating the potential liability created. In addition, many lawyers lacked complete understanding of the relationship between these warranties and the indemnification provisions in private agreements. For example, they often failed to recognize the need to strip materiality qualifiers out when a de minimis was present, failed to generally appreciate double materiality qualifiers and their effect on closing and indemnification, and often argued vociferously that the limitations on indemnification should apply to the covenants. I think much of the reason for this is firm incentives to train associates are diminished in the billable hour world and instead the firms tend to over-rely on their form and network effects (i.e., they will learn on the job from other attorneys) to substitute for this needed training.
Prof. Miller and I have had an off-line conversation on this case. I understand he is going to write a post on it over at Truth on the Market which I will link to when it is up.