Court opinions coming out of the Delaware Chancery Court are a delight to read. They are almost always clear and incisive. They are important and influential. That court doesn’t often “see” real estate disputes, but that doesn’t mean its work is irrelevant to our chosen day jobs. One such decision, published on November 24, does an incredible job of dealing with an agreement’s “we didn’t rely on any representations you don’t find in the text of this agreement” provision and that agreement’s “integration” or “merger” clause. As a bonus, it sheds some light on how and whether the fairly standard indemnification provision covers damages directly incurred by the indemnified party (a “first” party), or just for claims against the indemnified party by a “third party.” Unless you go directly to the Court’s written decision, you’ll need to keep reading if you want the answers [to all but the “indemnification” part; for that, you’ll need to wait until next week’s posting].
[So, for those who prefer to go right to the source of today’s blog posting, they can click HERE to see what Vice Chancellor J. Travis Laster had to say in Prairie Capital III, L.P. v. Double E Holding Corp.
This was NOT a real estate case. It involved one private equity fund selling one of its portfolio holdings, a company that made paper-handling equipment, to another private equity fund. For what it is worth, the Stock Purchase Agreement for this sale was signed at the closing table.
If the allegations are to be believed, and they seemed pretty credible, fraud by the seller permeated every aspect of the sale. To best understand the importance of what the Delaware court was saying, accept that there was such fraud. [This court decision didn’t rule on the “facts,” but decided that even if the allegations of fraud were true, it would be, for the most part: “too bad” for the buyer.
The seller “pitched” the company as a “growth story.” Its financial statements showed “steady increases in revenue, earnings, and operating capital during 2010 and 2012.” It told the buyer (prospective at the time) that the trend was likely to continue in 2012 and beyond. [Closing took place on April 4, 2012.] The seller “described the Company as a cash-generating business that had an excellent record of collecting accounts receivable and maintaining a strong net working capital position.”
All of that was of critical importance to the buyer, so much so that it made clear to the seller that “the Company’s sales during March  were critical to [its] willingness” to sign the purchase agreement and close. The seller projected sales of $3.2 million for that critical month of March. The buyer and seller monitored sales and order backlog on a daily basis. Sales were recorded when goods were actually shipped. By March 19, anemia was apparent. Sales had only reached $1.1 million, $2.1 million short of the critical number. On March 23, the seller reported sales of $1.53 million, but projected $1.67 million in sales during the last eight days of the month. Somewhat skeptical, the buyer questioned the figures, but the seller explained that its forecast was accurate and had been prepared in compliance with internal policies and GAAP (Generally Accepted Accounting Principles).
As one can imagine, there was a lot of back and forth discussion over those eight days, with the buyer expressing concern and the seller exuding confidence.
There were a lot of other things going back and forth at the company itself. To the company, it was clear that the $3.2 million threshold was not going to be met. All business trips were cancelled. Employees picked apart the order pipeline to see what could possibly be manufactured and d shipped. It was concluded that sales (shipments) would fall about $650,000 short and that would kill the deal.
So, the financial records were falsified to show March sales of just over the critical $3.2 mark.
The company identified pending orders that were close to their anticipated manufacturing and shipping dates. It then issued false (backdated) invoices and booked those as sales.
In reliance on the sales figures, the buyer signed the purchase agreement and the deal closed.
[Hang on for a continuation of this story, more egregious than that thus far told. But first, a little interruption to review some “law.” By “hang on, we mean until next week.]
The purchase agreement had a pretty long, but fairly standard (for these types of agreements), “Non-Reliance” provision. We present below it in its full glory. It isn’t unusual to see something similar in agreements for the sale of real property and to see truncated versions in many leases:
The Buyer acknowledges that it has conducted to its satisfaction an independent investigation of the financial condition, operations, assets, liabilities and properties of the [the seller’s] Companies. In making its determination to proceed with the Transaction, the Buyer has relied on (a) the results of its own independent investigation and (b) the representations and warranties of the [Seller] expressly and specifically set forth in this Agreement, including the Schedules. SUCH REPRESENTATIONS AND WARRANTIES BY THE [SELLER] CONSTITUTE THE SOLE AND EXCLUSIVE REPRESENTATIONS AND WARRANTIES OF THE [SELLER] TO THE BUYER IN CONNECTION WITH THE TRANSACTION, AND THE BUYER UNDERSTANDS, ACKNOWLEDGES, AND AGREES THAT ALL OTHER REPRESENTATIONS AND WARRANTIES OF ANY KIND OR NATURE EXPRESS OR IMPLIED (INCLUDING, BUT NOT LIMITED TO, ANY RELATING TO THE FUTURE OR HISTORICAL FINANCIAL CONDITION, RESULTS OF OPERATIONS, ASSETS OR LIABILITIES OR PROSPECTS OF DOUBLE E AND THE SUBSIDIARIES) ARE SPECIFICALLY DISCLAIMED BY THE [SELLER].
You’ll also want to cogitate over the agreement’s “integration” clause that makes all prior understandings, communications, hopes, and expectations disappear:
This Agreement . . . set[s] forth the entire understanding of the Parties with respect to the Transaction, supersede[s] all prior discussions, understandings, agreements and representations and shall not be modified or affected by any offer, proposal, statement or representation, oral or written, made by or for any Party in connection with the negotiation of the terms hereof.
So, as to all of the bad stuff that the seller did before the agreement was signed (on the day of closing), and you’ll hear more about bad stuff as we troll onward, none of that gave the buyer the basis for suing the seller. All of the fraudulently false statements and materials furnished to the buyer before the agreement was signed contained what the court described as “extra-contractual misrepresentations.”
Before we proceed, a caution is called for. When it comes to enforcing agreements, courts fall along a spectrum. At one end are those characterized as contractarian. Those are ones that, for the most part, make the parties suffer by the words chosen in their “contract.” At the other end are courts best described as “paternalistic.” They seek to protect weaker parties as if those parties were the court’s children. Delaware courts are the flag bearer for contractarianism. So, depending on what court would hear a dispute, such as the one we’re writing about today, the outcome might be different and the parties might wind up in opposite places.
What we just wrote is important. In a small, but important, number of situations, “where” a case is heard will affect its outcome. Without doubt, allegations of “fraud” trigger emotional responses and various jurisdictions (and individual judges) have adopted different attitudes toward protecting the aggrieved party. Universally, courts strive to protect vulnerable parties (individuals, aged, etc.) with less vigor than “real” business people. “Real” business people better pay attention to “venue” and “choice of law” provisions.
So, here is what contractarian Delaware judge-made law has to say:
Delaware law enforces clauses that identify the specific information on which a party has relied and which foreclose reliance on other information.
By specifying the information on which they have relied, parties “minimize the risk of erroneous litigation outcomes by reducing doubts about what was promised and said.”
[A] party cannot promise, in a clear integration clause of a negotiated agreement, that it will not rely on promises and representations outside of the agreement and then shirk its own bargain in favor of a ‘but we did rely on those other representations’ fraudulent inducement claim.
Go back and look at the lengthy “Non-Reliance” provision we reproduced above. It doesn’t merely say that the buyer wasn’t relying on any representations other than those in the purchase agreement. It affirmatively says that the buyer CAN’T, WON’T, and DIDN’T rely on any representations outside of the agreement. It didn’t have to use the words we put in upper case letters. The words it uses do the trick. Vice Chancellor Lester said it this way:
If a party represents that it only relied on particular information, then that statement establishes the universe of information on which that party relied. Delaware law does not require magic words. In this case, the Exclusive Representations Clause and the Integration Clause combine to mean that the Buyer did not rely on other information. They add up to a clear anti-reliance clause.
Why did he say it that way? It’s because of prior Delaware case law that says:
Murky integration clauses, or standard integration clauses without explicit anti-reliance representations, will not relieve a party of its oral and extra-contractual fraudulent representations.
To be effective, a contract “must contain language that, when read together, can be said to add up to a clear anti-reliance clause by which the plaintiff has contractually promised that it did not rely upon statements outside the contract’s four corners in deciding to sign the contract.”
So, take another look at the “integration” (or “merger”) clause. Are your similar clauses as comprehensive?
The buyer’s attorney clearly knew they were facing a battle with respect to the extra-contractual misrepresentations. So, they argued that it wasn’t only the affirmative misrepresentations that caused harm, but was also the material “omissions.” That argument went nowhere. They might have gone somewhere in a paternalistic court environment, but not in Delaware. There, the court pointed out that, other than where there is a fiduciary relationship (one of “trust”) between the parties, no party has an affirmative duty to speak. Contracting parties are permitted to “define in an agreement ‘those representations of fact that formed the reality upon which the parties premised their decision to bargain.” “Of course, if a party in an arms’ length negotiation chooses to speak, then it cannot lie.”
Here are the punch lines in Delaware and wherever else a court will not act as a parent-protector to commercial parties:
Because a party in an arms’ length contractual setting begins the process without any affirmative duty to speak, any claim of fraud in an arms’ length setting necessarily depends on some form of representation. A fraud claim in that setting cannot start from an omission. For arms’ length counterparties, therefore, contractual provisions that identify the representations on which a party exclusively relied define the universe of information that is in play for purposes of a fraud claim. A party may use external sources of information to plead that a contractually identified fact was false or misleading, but a party cannot point to extra-contractual information and escape the contractual limitation by arguing that the extra-contractual information was incomplete. There is also a powerful practical rationale underlying this approach. “Every misrepresentation, to some extent, involves an omission of the truth . . . .” Consequently, any misrepresentation can be re-framed for pleading purposes as an omission. If a plaintiff could escape a provision like the Exclusive Representations Clause by re-framing an extra-contractual misrepresentation as an omission, then the clause would be rendered nugatory. When parties identify a universe of contractually operative representations in a written agreement, they remain in that universe. A party that is later disappointed with the written agreement cannot escape through a wormhole into an alternative universe of extra-contractual omissions.
Our apologies for such a lengthy quote from the court’s opinion, but (if you recall from way above), we are enamored with the general quality of writing in “Delaware Chancery” and don’t think we could do better.
We’re going to stop here, but you’ll want to read next week’s Ruminations blog posting when we tell you what actually went on in the years before the critical month of “March, 2012” and you’ll be even more puzzled about the outcome. We’ll cover one important concept about indemnity clauses. We’ll also tell you about a similar case before a California court and then try to distill some lessons that will enable all of us to write agreements that say what we mean and mean what we say.