United States: Ruling in "ABRY Partners v. Providence Equity" Case Has Lessons for Buyers and Sellers (Private Equity Update)

What happens when one private equity firm buys a portfolio company from another private equity firm, and then sues the selling firm for allegedly knowing that the portfolio company’s financial statements were misstated? On February 14, 2006, the Delaware Court of Chancery ruled on a motion filed by private equity firm Providence Equity Partners to dismiss a case brought against it by another private equity firm, ABRY Partners, seeking to undo the $500 million sale by Providence to ABRY of F&W Publications. The ruling dismissed a number of claims brought by ABRY, but left open the possibility of an ABRY victory if it ultimately proves that Providence participated in what the judge called "the communication of lies" to ABRY with respect to the representations and warranties in the purchase agreement. The ruling sets up what could be a bitter trial, and provides lessons for both private equity buyers and sellers.

The case arose three months following the closing of the sale of F&W Publications. It involves allegations by ABRY that F&W, a seller of special interest books and magazines, artificially inflated its EBITDA, and that Providence either caused that misstatement or knew about it. The complaint alleges that F&W’s EBITDA was overstated through a variety of fraudulent practices including, among others, channel stuffing, "back starting" (the practice of sending multiple back issues of a magazine to a new subscriber in order to accelerate revenue recognition), using erroneous financial estimates, establishing inadequate reserves and improperly accelerating the shipment of magazines. According to ABRY, which allegedly priced the deal at a multiple of 10X EBITDA, the inflated EBITDA caused ABRY to overpay by at least $100 million. When ABRY discovered the financial irregularities after the closing, it sued Providence in the Delaware Court of Chancery in an attempt to rescind the transaction and recover its capital.

Providence’s attempt to dismiss the case focused on provisions in the stock purchase agreement designed to insulate it from liability following the closing (at least for claims in excess of the $20 million indemnification cap negotiated in the agreement). In particular, the agreement (which was governed by Delaware law) included:

• a disclaimer of any representations and warranties other than those expressly set forth in the purchase agreement;
• an agreement by ABRY that it was not relying on any representations, warranties or other information not included in the purchase agreement, including anything made available in "data rooms," management presentations or discussions prior to signing;
• an exclusive remedy provision limiting ABRY’s recourse for breaches of representations and warranties to the negotiated indemnification provisions; and
• an integration clause providing that the purchase agreement superseded all prior agreements between the parties, both written and oral.

The exclusive remedy provision in the purchase agreement did not exclude fraud claims from its otherwise exclusive nature, nor did the representations in the purchase agreement expressly address channel stuffing, back starting or the other alleged practices. The agreement did not include every possible provision available to sellers to insulate gains from post-deal claims (e.g., an anti-sandbagging clause), but it included most of them. The Providence funds and management company that were sued were not parties to the purchase agreement and thus did not make any of the representations and warranties, a fact not addressed in the decision. A Providence officer did, however, sign a certificate on behalf of F&W, the Providence-controlled target company, that F&W’s representations and warranties were true and correct as of the closing date.

Providence defended the allegations by arguing that its liability should be limited to the $20 million indemnification cap it had negotiated in the purchase agreement, even if it could be proven that it or F&W management had lied to ABRY about the company’s results of operations. ABRY countered that the deal should be unwound even if Providence had only been grossly negligent or negligent in making false representations, since the misrepresentations were so material. The court ultimately came out in the middle. It ruled that Providence’s liabilities would be limited to the $20 million cap, provided it did not lie. However, if ABRY could prove Providence knowingly misled it, either because Providence knew that F&W’s contractual representations and warranties were false or that Providence itself lied to ABRY about a representation and warranty, then ABRY could collect damages in excess of the indemnification cap or possibly have the deal rescinded.

Buyers and sellers should both be aware of key points suggested by the Chancery Court’s decision when negotiating acquisition agreements:

• In the absence of fraud, a Delaware court will generally enforce liability limitations in favor of sellers no matter how material the underlying claim. Buyers will need to account for that fact as part of their risk analysis before agreeing to those provisions under Delaware law.
• No matter what the liability limitations say, sellers are always liable for their own fraud.
• If drafted properly, purchase and sale agreements can insulate private equity firms from fraud committed by management of their portfolio companies in connection with a sale as long as they are not actually aware of it.

There is more to come in this case, principally the detailed evidence pertaining to whether Providence actually knew about the alleged financial misstatements. The court papers include some previews of this evidence, including references to a number of potentially damaging e-mails (e.g., the alleged statement of F&W’s CEO in an e-mail to F&W officials, in reference to the second quarter financial projection previously given to ABRY, but not warranted in the purchase agreement, that, "We’re going to have trouble with June numbers and it could be a calamity," and the alleged statement by a Providence employee to F&W management that management should "get [ABRY] to the right EBITDA number" in light of the 10X multiple being paid). Ironically, the more involved and "hands on" a private equity firm is in monitoring the performance of a portfolio company, the more likely it is to be charged with knowledge of misstatements in the company’s financials. It is important for private equity owners to be clear that pressure on portfolio company management to "make its numbers" does not mean that GAAP violations are encouraged or will be tolerated. After hundreds of pages of legal debate regarding the terms of the acquisition agreement, evidence about what Providence knew will decide this case.

More broadly, the ABRY case reflects a number of trends and conditions in private equity M&A. The F&W transaction is one of an ever increasing number of private equity-to-private equity liquidity transactions. In these transactions a relatively common set of indemnity terms has emerged, not infrequently including termination of representations at closing. In this environment disputes involving alleged fraud may become more common, both as a means of overriding contractual limits on indemnity and because suspicion or evidence of fraud tends to infuriate buyers who may otherwise be adverse to litigation. In this environment, monitoring of internal communications and records of these communications becomes ever more crucial. And finally, the case arises in a private equity market that has grown ever larger, that is affected by intense competitive pressures and in which the level of familiarity and collegiality among general partners may be less than it was a generation ago. While perhaps not materially on the rise, litigation between private equity firms in this environment is unlikely to decrease.

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