But, Not Everyone Can Get Away With Fraud By Clever Drafting

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Today, we continue our story of how to get away with fraud and deception. For those of you who were, as the Brits say, on “Holiday” last week (yes, England and the United States, two nations separated by a common language), you can catch up by clicking HERE.

Last week, we described how the seller of a company was able to hide behind an agreement’s provision wherein the buyer agreed that it was relying only on the information and representations recited in the agreement. Then, by signing the agreement on the day of closing, it could only complain about what happened between signing and closing. At best, that was a few minutes or so. Perhaps our readers accepted that as fair because the buyer was carefully monitoring the company’s revenues for March of 2012, the critical “test” month. It knew that the sales figures were somewhat implausible and should have known that the “last minute” jump in revenue was “strange.” Maybe, that’s why the Delaware Chancery Court was unwilling to parcel out a little of the “equity” for which chancery courts were developed. (OK, that explanation is a stretch, but we’re not ready to concede that the words “justice” and “business” are in different dictionaries. But, how about the rest of last week’s story?)

[Ruminations is well aware that those who missed last week’s “first” installment may very well be lost at this point, so we again recommend that if you are in that group, you click HERE.]

The sale took place in April of 2012, but the seller began falsifying the company’s records as early as the summer of 2011 to “maintain the appearance of an upward trend.” Such falsification included shipping “previously manufactured products to false or non-existent addresses on the last day of a given month only to have shipments returned to the Company and incur thousands of dollars of unnecessary shipping costs.” Month after month, that inflated the Company’s monthly sales results and accounts receivable.

The court’s opinion is lengthy and Ruminations is not going to repeat all that it said. As to the seller’s acts of fraud as alleged by the unhappy buyer, what readers need to know is that the buyer was substantially unsuccessful because of three key and common provisions found in all manner of agreements. Note, that we say “substantially” unsuccessful, because the buyer’s allegations as to the seller’s breach of some limited contractual representation did survive dismissal on their face, but they represented only a small part of the overall fraud claimed by the buyer.

The first is that the buyer was not able to assert reliance on what the seller told it if that same information was not written into the agreement itself. Delaware courts can be harsh in that regard, giving no leeway for pleas of “but that isn’t fair.” Other state’s courts might act the same way.

The second reason is something we haven’t brought up earlier. The purchase agreement set aside part of the sales proceeds into an escrow fund and for claims to be made against that fund, they would have to be articulated by a given date, one that was about 15 months after the closing. The buyer made a timely claim, but did not express any complaint about anything that had taken place other than with respect to the “test” month that immediately preceded the closing. Fraudulent or not, the buyer’s failure to “reserve” such claims precluded a later, successful law suit. No matter whether expressed as breach by the seller of an affirmative representation or as omissions by the seller, the buyer didn’t give timely notice to its seller.

The third has to do with exactly “when” the buyer’s representations “spoke.” In this case, they spoke only as of the date given. So, even though the buyer had relied on earlier financial statements, when the seller only represented that a specifically dated financial statement, the most recent one, was substantially accurate, that’s the only financial statement the buyer could complain about. The lesson is to have a party’s representations cover what you have actually relied on.

By this time, most readers should be screaming, “but this was FRAUD.” There is a general thought that fraud overrides whatever an agreement might say in the way of limiting the “bad” party’s liability. A lot of agreements include a self-explanatory “exclusive remedy” provision, and many think that no matter what such a provision says, you can always recover for “fraud.” In today’s example, the purchase agreement went beyond the most common approach and included a “carve-out” for act of fraud. Take a look at this:

[e]xcept as provided in [sections relating to post-closing covenants and the payment of a specific note], equitable remedies that may be available, or in the case of fraud, the remedies set forth in this Article X [relating to indemnification] constitute the sole and exclusive remedies for recovery of Losses incurred after the Closing arising out of or relating to this Agreement and the Transaction.

Yes, it would appear that the parties were careful to say that even if the purchase agreement limited one’s remedies to those set forth in a particular section of the agreement, that limitation was out the window for damages caused by fraud. The “rub” is that the quoted section of the purchase agreement only “expanded” the remedies that were available, but not the “rights” that could be violated that would trigger those remedies. In our parlance, a “right” that is violated becomes a “wrong” and you get a remedy when you’ve been “wronged.”

So, if there is no “wrong” and that could be, as was mostly the case here, because the representations were narrowly framed and there was a “claim” cut-off date, the buyer wound up with no or very few wrongs that it could pursue. Basically, the buyer had an open-ended list of available remedies, but only if it could show that the seller had acted fraudulently in violating the purchase agreement. That meant the seller could have been perpetrating fraud left and right, but if the buyer agreed that it wasn’t relying on how the seller was acting, the open-ended list of remedies had no “wrong” against which it could be applied.

At this point, we are left with one remaining interesting issue that came up in this case. In the purchase agreement, the “company” itself made all the representations, including the few that the Delaware court found actionable. [Yes, there were a few left after the court threw most of the allegations out the window.] The buyer sued the people who controlled the company alleging that those individuals had made the false representations. As expected, those individuals “contend[ed] that they [could not] be accountable for any of the representations because they were made only by the Company.” This defense didn’t go down well with the court.

Vice-chancellor Laster republished the following text from Restatement (Second) Torts § 533: “[t]he speaker who makes a false representation is, of course, accountable for it. But a party also is accountable ‘if the misrepresentation, although not made directly to the other, is made to a third person and the maker intends or has reason to expect that its terms will be repeated or its substance communicated to the other, and that it will influence his conduct in the transaction.’” He continued by noting the following comment (in that same section of the Restatement): “If the misrepresentation is made for the purpose of having it communicated, the maker is subject to liability.”

The beauty (and scary part) of what Chancellor Laster pointed out is that the buyer’s claim against the company’s directors and others who controlled the company was not based on a contractual breach, but was based on a “tort” or “civil harm.” For those not familiar with what makes a tort a “tort,” here is the briefest of explanations. People have certain common duties, such as not to ram their cars into other cars. One of those common duties is not to mislead people who you know or should know will be relying on what you say. If you violate that duty and someone to whom that duty was owed (such as another driver or, as in this case, someone buying your company), and they – the other driver or the buyer – are harmed, you have committed a “tort.” To commit a “tort,” you don’t need a prior agreement that you will act in a certain way or refrain from acting in a certain way. You just need a “duty” to “act” or “refrain from acting” and that duty can arise out of a law or out of social (actually, civil) convention.

Corporations, though considered to be “persons” for certain purposes, can only act through humans, and “[a]s the human through which the corporate principal acts, ‘[a] corporate officer can be held personally liable for the torts he commits and cannot shield himself behind a corporation when he is a participant. … This includes situations where a corporate agent participates in corporate fraud. … It is immaterial that the corporation is also liable. … A corporate officer or agent who commits fraud is personally liable to a person injured by the fraud. … Therefore, ‘[a]n officer actively participating in the fraud cannot escape personal liability on the ground that the officer was acting for the corporation.’”

So, here are words of caution. Reading the words of a contract is not enough to know what obligations, duties, rights, and remedies parties may have or have to each other. There is “law” involved. Agreements are enforced within a universe of laws. Basically, all agreements incorporate all of the law that is in effect in the jurisdiction. Here, even though a plain reading of the purchase agreement could lead one to believe that only the company would be liable if it fraudulently made a representation, that’s just not the case. Though “contract” law would lead to such a result, “tort” law can go beyond the words of the contract. Those controlling the company would not have personal exposure if, without the fraud, the company’s representations turned out to be false That’s because those individuals took on no personal duty to make sure that such representations were accurate. But, the general “civil” law says that people should not act to defraud others and, for that reason, those controlling the corporation had a “civil” duty not to cause the fraudulent representations to be “said” by the corporation.

Admittedly, the seller we’ve written about this week and last did not get away with all of its fraud, but only a lot of its fraud. And that’s because of the words of limitation in a purchase agreement. We know that doesn’t feel right and we know that not every jurisdiction would let that happen even if Delaware would. None the less, there is an important lesson to be learned here. If you agree that you are only relying on representations set forth in the agreement itself, don’t expect a court to bail you out when it won’t countenance any “cries” that “we wuz robbed” by what was told to you outside of the agreement, not even if the intent of telling you was to defraud you.

Those who read last week’s posting (and remember what was in it), will remember that we promised we would also report and comment on a recent California court decision. We re-read that opinion and, rather than deciding it was unworthy, we concluded that it deserved its own showcase. That, combined with a sense that Ruminations has already “gone far too legal this week and last,” we thought we shouldn’t double down today. So, if you still have any appetite for some more “legal” stuff, tune in next Sunday when we’ll tiptoe through an early December California Appellate Court decision with lessons that overlap those of the last two weeks.

We look forward to 2016 and hope you do as well.

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Comments

  1. It would be interesting to hear what happen between the buyer and their legal counsel as a result of this transaction process as well as the follow on legal actions.

    Best wishes for the new year. /s/ James T Saint, CCIM

  2. Tim Scott says:

    Excellent article (both parts) and fair warning. As you note, the fraud would not have been ignored in many other jurisdictions (such as California). This is good notice that while the statutes may be similar in different states, the case outcome could be reversed depending on such less obvious interpretation issues. Be forewarned when accepting a choice of law that is not the state you practice in. I have been practicing for 30 years in California and would not have expected such willful, blatant and intentional fraud and cooking of the books in order to satisfy a clear condition ($3.2 Mil in March sales), which apparently was not a representation re those sales, would be blessed by the court. If the agreement wasn’t signed until closing, they might have argued fraudulent inducement and for recission.

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