The recent "credit crunch" and the stress that it places on the M&A marketplace has increased the number of broken deals in which buyers seek to exit transactions due to frustrated expectations. As these busted deals lead to litigation, important lessons that can be of value to M&A practitioners are coming out of the court decisions. This Article highlights some of the lessons to be learned by deal professionals from four recent cases: Abry, Allegheny, Genesco , and URI .1By incorporating these lessons into their deal activity, Buyers and Sellers can ensure that their expectations are respected, and potentially can gain a competitive advantage over others in the marketplace.
Lesson: Put Some "Pizzazz" in Your Diligence and Protect it by Contract
The Different Models of Diligence
There is a tension inherent in the law and in the expectations of practitioners regarding the role of business diligence in M&A transactions. This tension arisesbetween two different paradigms: (1) the Antifraud Paradigm and (2) the Risk Allocation Paradigm. Each of these paradigms encompasses two elements, the Disclosure Obligation to provide business diligence and the Liability Exposure if business diligence proves to be false or misleading. The following chart summarizes the two paradigms:
Antifraud Paradigm
Disclosure Obligation
Seller must disclose all information that is material to the business.
Liability Exposure
Seller is liable if business diligence is false or misleading.Seller has no liability for matters disclosed in business diligence.
Risk Allocation Paradigm
Disclosure Obligation
Seller has to disclose only that information requested by Buyer.
Liability Exposure
Seller has liability only for those things specifically enumerated in the Acquisition Agreement and only to the extent provided in the Acquisition Agreement.
The extent to which each of these paradigms governs a particular transaction depends on the statutes and common lawand the terms of the Acquisition Agreement between the parties. There is no right or wrong answer as to which paradigm should be adopted. However, practitioners need to understand how courts are applying the paradigms and adjust their actions accordingly.
The Trend In Liability Exposure
The trend in Acquisition Agreements is for the parties to adopt the Risk Allocation Paradigm for Liability Exposure. Through the terms of the Acquisition Agreement, parties increasingly eliminate the background legal rules that have developed over the years, and instead rely solely on the rights and remedies provided for in the Acquisition Agreement. Presumably this trend is driven by a level of economic efficiency, in that the price that Sellers would demand to expose themselves to the Antifraud Paradigm of Liability Exposure is greater than the added purchase price Buyers would be willing to pay for the increased protection provided by the Antifraud Paradigm. Courts in recent cases have been willing to respect this choice among sophisticated business parties, but move back to the Antifraud Paradigm when an injured party can demonstrate that the other party acted in a consciously improper manner.
A Seller achieves the Risk Allocation Paradigm for Liability Exposure by having the Buyer represent that it is not relying on any representations and warranties outside of the Acquisition Agreement and by having the agreement provide that the Buyer's exclusive remedy for a breach is the remedy provided for in the agreement. These provisions taken together have two consequences.
The first consequence of the Risk Allocation Paradigm for Liability Exposure is that the Buyer will be placed in a position of the "double lie" if it seeks to recover for false or misleading business diligence that is not covered by a representation or warranty in the Acquisition Agreement. The "double lie" arises because while the Seller may have lied in diligence, the Buyer also lied when it said that it wasn't relying on any representation or warranty outside of the Acquisition Agreement. That "double lie" destroys the legal argument of reliance.2So when the Seller's business person tells the Buyer that the business is "on plan," the Buyer will not have a remedy if the business is "off plan" unless that statement is covered by a representation and warranty in the Acquisition Agreement.
The second consequence of the Risk Allocation Paradigm for Liability Exposure is that the Buyer will be limited to the remedies in the Acquisition Agreement if any of the representations and warranties prove to have been false. These remedies usually have limited time periods in which they can be asserted and some form of deductible or damages threshold and an overall cap on liability. Courts will respect a provision in an Acquisition Agreement that excludes all other remedies, in order to avoid spurious fraud claims bought between sophisticated parties at a later date.
The Abry case demonstrates the circumstances in which a court will move from the Risk Allocation Paradigm to the Antifraud Paradigm. In, Abry a private equity seller sold a portfolio company to a private equity buyer. The court treated the case as involving three separate parties: the Seller, the Company being sold, and the Buyer. As is typical in such transactions, the representations regarding the Company's business in the Acquisition Agreement were made by the Company, not the Seller, and the Seller agreed to indemnify the private equity Buyer for breaches of those representations, subject to contractual limitations on damages. The agreement contained the "double lie" provision (in which the Buyer represented that it was not relying on any representations outside of the Acquisition Agreement) and an exclusive remedies provision limiting the Buyer to $20 million in damages. The Buyer, in essence, claimed that the Company's books had been cooked at the direction of the Seller, and sued for rescission (seeking to return the Company to the Seller in exchange for a refund of the purchase price), which was a remedy not provided for in the Acquisition Agreement. The Delaware Court of Chancery began with the premise that it should give great "leeway to sophisticated business parties crafting acquisition agreements." The Court found that the parties had allocated to the Buyer the risk that the Company lied in the Acquisition Agreement, and it saw no reason to upset that allocation. However, the Court voided as against public policy the provision of the Acquisition Agreement in which the Seller allocated to the Buyer the risk that the Seller lied in the Acquisition Agreement. Specifically, the court held that:
"To the extent the [Acquisition Agreement] purports to limit the Seller's exposure for its own conscious participation in the communication of lies to the Buyer, it is invalid under the public policy of [Delaware] . . . this State will not permit the Seller to insulate itself. . . if the Buyer can show either: 1) that the Seller knew the Company's contractual representations were false; or 2) that the Seller itself lied to the Buyer about a contractual representation and warranty. This will require the Buyer to prove that the Seller acted with an illicit state of mind. . . . By contrast, the Buyer may not obtain rescission or greater monetary damages upon any lesser showing. If the Company's managers intentionally misrepresented facts to the Buyer without knowledge of falsity by the Seller, then the Buyer . . . must proceed with an Indemnity Claim subject to the [] liability cap. Likewise the Buyer may not escape the contractual limitations on liability by attempting to show that the Seller acted in a reckless, grossly negligent, or negligent manner. The Buyer . . . has no moral justification for escaping its own voluntarily accepted limits on its remedies against the Seller absent proof that the Seller itself acted in a consciously improper manner."
While the Court acknowledged that it was allowing the Buyer to "get away with" a double lie, it found this far less compelling a problem than where the Seller consciously lied. 3The Court does not address the issue of whether it would respect the Risk Allocation Paradigm with regard to "lies" on matters not within the four corners of the Acquisition Agreement, but a close reading of the decision gives one the impression that there is a substantial likelihood that the Court would uphold the Risk Allocation Paradigm in that circumstance.
The lesson of Abry for Sellers is that if they are selling for a Risk Allocation Paradigm purchase price, a standard "double lie" and limitations on remedies in the Acquisition Agreement will not achieve that result. Instead, Sellers should employ one of two techniques. First, they should make no representation or warranty directly, but instead should have the target company make all representations and warranties. Second, they could use a tactic I recently employed, which was to have the Seller make a representation only as to "due authorization" and to have all other negotiated matters stated as "assumptions" for which there were contractually defined indemnities if the assumptions were not true.
The Allegheny case discusses (but ultimately is not decided upon) the other side of the coin: how the Seller can move to an Antifraud Paradigm and avoid the contractually imposed Risk Allocation Paradigm when the Buyer closes knowing that a risk allocated to the Seller has already come to pass. In Allegheny , the Second Circuit, applying New York law, reaffirmed the general principle that "a buyer may enforce an express warranty even if it had reason to know that the warranted facts were untrue," in essence upholding the Risk Allocation Paradigm. However, the Court goes on say that "where the seller has disclosed at the outset facts that would constitute a breach of warranty, that is to say the inaccuracy of certain warranties, and the buyer closes with full knowledge and acceptance of those inaccuracies, the buyer later cannot be said to believe he was purchasing the seller's promise respecting the truth of the warranties." In other words, while the Court will accept the Risk Allocation Paradigm for unknown events, if a Buyer truly knows of a breach and wants compensation for it, presumably the Buyer cannot "defraud" the Seller and obtain contractual indemnity for breach of representation and warranty, but must ask for an express indemnity.
While Sellers may like this aspect of Allegheny , Buyers are likely to view it as "less than Risk Allocation." In my experience, most Buyers will seek to reverse this outcome with an express provision of the Acquisition Agreement to the effect that the Buyer's knowledge does not affect the Buyer's ability to obtain indemnification for breach of representation or warranty.
Next month:The Disclosure Obligation and other lessons. 1 Abry Partners V, L.P. v. F&W Acquisition LLC, 891 A.2d 1032, (Del. Ch. 2006); Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc., 500 F.3d 171 (2d Cir. 2007); Genesco, Inc. v. The Finish Line, Inc., Memorandum and Order, dated December 27, 2007 (Tenn. Ch. 2007); and United Rentals, Inc. v. RAM Holdings, Inc., 937 A.2d 810 (Del. Ch. 2007).
2 Abry, 891 A.2d at 1058 ("[t]o fail to enforce no-reliance clauses is not to promote a public policy against lying. Rather it is to excuse a lie made by one contracting party in writing - the lie that it was relying only on contractual representations and that no other representation had been made.").
3 See Abry, 891 A.2d at 1064-65 (voiding as against public policy a limitation on remedies for fraud only to the extent based on the contractual representation and warranty).
Published March 1, 2008.
