United States: Significant 2015 Decisions Affecting Private M&A: Part 2

The following compilation is Kaye Scholer's second annual review of significant Delaware court decisions relating to private merger and acquisition transactions and disputes. The decisions here, all issued in 2015, are organized in the following sections: proxy contests and other disputes involving the board; fraud claims in M&A transactions; deal mechanics; employee and options matters; and decisions interpreting Delaware's recently adopted statutes governing ratification and validation of corporate acts.

This review is split into a three part-series. Part two includes decisions involving fraud claims in M&A transactions, and decisions involving deal mechanics.

Fraud Claims in M&A Transactions

1. Aviation West Charters LLC v. Jeremy Freer, C.A. No. N14C-09-271 WCC CCLD (Del. Super. Ct. July 2, 2015)

The court ruled that (1) integration clause does not preclude fraudulent inducement claim based on materially false financial statements where the integration clause does not contain an express disclaimer of reliance, and (2) the founder, president and CEO could be liable for fraudulent inducement, even though he did not make representations under the purchase agreement, where the plaintiff alleged he made oral and written representations and concocted the fraudulent scheme.

This decision involved a motion to dismiss in a dispute stemming from the sale of an air ambulance business (the company). Prior to its sale, the company was operated by another company (JTF), of which defendant Freer (together with JTF, the "JTF defendants) was the founder, owner and president. The company's business model was to charge a $14,000 retainer and seek the remaining fees, which averaged $380,000 per flight, from the patient's insurer. Collections from insurers varied significantly.

The company's financial statements were prepared on a modified cash (as opposed to accrual) basis and were typically reviewed but not audited. In connection with its sale, the company prepared accrual financials intended to comply with generally accepted accounting principles (GAAP) for its 2013 fiscal year, and retained an independent accountant, CliftonLarsonAllen LLP(CLA) to audit them. CLA proposed adjustments, principally to the valuation of net accounts receivable, which resulted in an increase in net income of approximately $30 million, and which the company accepted prior to CLA issuing a clean audit opinion. The 2013 audited financials showed 2013 earnings before interest, taxes, depreciation, and amortization (EBITDA) of $40.8 million and net accounts receivable (A/R) as of Dec. 31, 2013, of $38.4 million.

In June 2014, following a marketed sale process, the company was sold to a private equity acquirer pursuant to an asset purchase agreement (the APA) for $80 million. The acquirer (the plaintiff) subsequently brought claims against the JTF defendants and another party for fraudulent inducement, and breach of contract, warranty and implied covenant of good faith and fair dealing, among others, based on allegations that the company intentionally overstated its accounts receivable and revenue by approximately $30 million.

In considering the motion to dismiss the fraudulent inducement claim, the court noted that in order to survive the motion, a plaintiff must allege that "(1) defendant falsely represented a material fact or omitted facts that the defendant had a duty to disclose; (2) defendant knew the representation was false or made with a reckless indifference to the truth; (3) defendant intended to induce the plaintiff to act or refrain from action; (4) plaintiff acted in justifiable reliance on the representation; and (5) plaintiff was injured by its reliance on defendant's representation."

With regard to the first element, Freer claimed that he could not be personally liable because he did not personally make any contractual representations. Rejecting this argument, the court noted that "it is well-settled law that officers and directors may be liable for tortious misconduct even though they were acting on behalf of the business." The court found that Freer "not only made numerous oral and written representations to Plaintiff about [the company], Plaintiff also alleges that Freer 'concocted' the fraudulent scheme .... Because of Freer's role as a President and CEO, and his involvement in the negotiation and sale of [the company] to Plaintiff, Plaintiff has sufficiently alleged a claim against him for fraudulent inducement."

The JTF defendants also argued that the plaintiff's fraud claims were impermissibly bootstrapped to its breach of contract claims, citing to authority that "where an action is based entirely on a breach of the terms of a contract ... and not on a violation of an independent duty imposed by law, a plaintiff must sue in contract and not in tort." The court rejected this argument, which equates to nonrecognition of claims for fraudulent breach, because it does not apply with respect to claims for fraudulent inducement.

With regard to the second element, the JTF defendants contended that the fraud claim related to a calculation of a GAAP-compliance estimate of A/R and not a misstatement of fact. Rejecting this argument, the court noted that the allegations related to improper inflation of A/R and 2013 EBITDA, which involved a statement of past fact and not of opinion or future conduct. The court also found that the third element was satisfied because the plaintiff alleged that Freer "knowingly concealed" the company's true financial condition, "knew all along" that Medicare flights were unprofitable, "knew" that the 28 percent collections rate was an overstatement, and "knew" that the EBITDA representation "was false" and the 2013 financials were "knowingly, intentionally, and purposefully false."

With regard to the justifiable reliance element, Freer contended that Section 12.2 of the APA precluded the plaintiff from relying on any representation made prior to entering into the APA. Section 12.2 set forth an integration clause, which provided in relevant part:

The Disclosure Schedule, the Schedules and the Exhibits referenced in this Agreement are incorporated into this Agreement and collectively with the Confidentiality Agreement and this Agreement contain the entire agreement between the parties hereto with respect to the transactions contemplated hereunder, and supersede all negotiations, representations, warranties, commitments, offers, contracts and writings prior to the date hereof, including the letter of intent dated, February 7, 2014, between the Vistria Group, LP and Seller.

The court noted that Delaware courts have "held that integration clauses will not be given effect to bar allegations of fraudulent inducement based on extracontractual statements made before the effectuation of the contract unless such clauses contain an explicit anti-reliance representation." The court found that Section 12.2 did not contain an explicit disclaimer of reliance, and thus did not bar the plaintiff's fraudulent inducement claim.

The court dismissed the breach of contract and warranty claims against Freer because the representations and warranties were only made by the "seller", which was JTF, and not by Freer. In denying the motion to dismiss the claim for breach of implied covenant of good faith and fair dealing, the court noted that the plaintiff's implied covenant contained in the financial statements representation "is that JTF would not artificially inflate any of the A/R in the Financial Statements that would induce Plaintiff to pay a higher price than it otherwise would if it knew the truth of the financial condition of AMF."

This decision provides a useful drafting tip with respect to integration clauses. In order to be able to rely on these clauses to dismiss fraudulent inducement claims, sellers should ensure that the clauses contain express disclaimers of reliance. The decision also provides a reminder to officers and directors that they can be held personally liable for fraudulent inducement, even though they may be acting on behalf of the company being sold. (The same judge provided similar guidance in another decision later in the year, TrueBlue Inc. v. Leeds Equity Partners IV LP, 2015 Del. Super. LEXIS 524 (Del. Super. Ct. Sept. 25, 2015)).

2. Prairie Capital III LP v. Double E Holding Corp., C.A. No. 10127-VCL (Del. Ch. Nov. 24, 2015)

The court gave expansive interpretation to "exclusive representations" language to preclude fraud claims based on alleged representations and omissions outside the share purchase agreement, and eschewed need for "magic words" as reliance disclaimer.

This case arose from the sale of Double E Parent LLC, a portfolio company of private equity firm Prairie Capital Partners, to an affiliate of another private equity firm, Incline Equity Partners (together with the affiliate, referred to as Incline).

In early 2012, while the sales process was ongoing, the company's CEO and chief financial officer recognized that the company was not going to meet the March sales target provided to Incline, and fabricated roughly $650,000 of sales in March to make it appear that the company had met its target.

Incline decided to buy the company after receiving the fabricated information. The parties executed a stock purchase agreement (SPA) and closed the same day. Among the SPA's representations and warranties were those for absence of changes, accounts receivable, financial statements and undisclosed liabilities, and compliance with laws. There was an escrow fund established to fund indemnification obligations from breach of representations and warranties. The SPA contained an "exclusive representations" provision that stated:

The Buyer acknowledges that it has conducted to its satisfaction an independent investigation of the financial condition, operations, assets, liabilities and properties of the Double E 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 Double E Parties expressly and specifically set forth in this Agreement, including the Schedules. SUCH REPRESENTATIONS AND WARRANTIES OF THE DOUBLE E PARTIES CONSTITUTE THE SOLE AND EXCLUSIVE REPRESENTATIONS AND WARRANTIES OF THE DOUBLE E PARTIES 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 SUBISIDIARIES) ARE SPECIFICALLY DISCLAIMED BY THE DOUBLE E PARTIES.

The exclusive representations clause was backed up by a standard integration clause, which provided that the SPA "set[s] forth the entire understanding of the Parties with respect to the Transaction, supersede[s] all prior discussion, understandings, agreements and representations ...."

Two days before the escrow release date, Incline submitted a claim notice, which indicated that Incline believed the company had engaged in fraud. The sellers' representative filed suit to compel the release of the escrow and Incline counterclaimed, asserting in part a claim for fraud by the company and its CEO and CFO, based both on the SPA representations and on extracontractual statements and omissions during the sale process and due diligence.

The court granted in part and dismissed in part Incline's motion to dismiss. The court found that Incline had waived the right to bring a claim of fraud regarding the extracontractual representations and omissions, but that Incline had shown it was reasonably conceivable that the CEO, CFO and selling stockholders could be held liable for the fraudulent contractual representations. The court also found Incline had sufficiently plead the claim of breach of several representations in the SPA.

The court held that Incline's claims based on extra-contractual representations were foreclosed by the exclusive representations and integration language in the SPA. The court noted that Delaware law enforces clauses that identify the specific information on which a party has relied and which forecloses reliance on other information, citing RAA Mgmt LLC. v. Savage Sports Hldgs Inc., 45 A.3d 107, 118-119 (Del. 2012). Incline argued that the language in the SPA, quoted above, was not a clear anti-reliance clause, relying on Anvil Holding Cor. v. Iron Acquisition Co., (Del. Ch. May 17, 2013).

The court acknowledged that disclaimer clauses are often stated negatively (i.e., the buyer is not relying on any statements not included in the agreement), while the clause in the SPA was framed positively (the buyer is only relying on the representations included in the agreement). The court concluded, however, that it was irrelevant whether the disclaimer was framed positively or negatively, so long as it clearly defined the universe of information Incline had relied upon, and in so doing excluded any other information on which Incline could state a claim. The court would not read Anvil to require "magic words" such as "disclaim reliance."

As a second argument, Incline attempted to avoid the exclusive representations language by claiming that it did not apply in the case of fraudulent omissions. In TransDigm Inc. v. Alcoa Global Fasteners Inc., (Del. Ch. May 29, 2013), then-Vice Chancellor Donald Parsons had held that an adequate disclaimer of reliance does not bar claims of fraudulent concealment if the buyer has not disclaimed reliance on extracontractual omissions; rather, the buyer must also disclaim reliance on "the accuracy and completeness" of the information provided to it by the seller.

The court rejected this reasoning, stating that "to the extent TransDigm suggests that an agreement must use a magic word like 'omissions,' then I respectfully disagree with that interpretation." Vice Chancellor Travis Laster noted that every misrepresentation involves to some extent an omission of the truth, and held that the SPA's exclusive representations and integration language, which defined the universe of information Incline was relying on, was sufficient to exclude a fraud claim based on an extracontractual omission.

It is worth noting that in Prairie Capital, Incline had simply recast its claims of affirmative misstatements as claims of omissions, with the same underlying facts giving rise to both the misstatements and the omissions. In contrast, in TransDigm the buyer had alleged that the seller had concealed the fact that it had offered a major customer a discount and was at risk of losing about half of that customer's business. The court there had held that the buyer could rely on the assumption that the seller had not actively concealed information or engaged in a scheme to hide that material information. Thus it is possible that a claim of concealment of information could survive an exclusive representations provision, so long as it is not simply a mirror image of the claims of reliance on misstatements. However, the two decisions cannot be wholly reconciled and it may be that the issue of when omissions are disclaimed will require the input of the Delaware Supreme Court.

As a third argument, Incline attempted to avoid the exclusive representations language by arguing that a separate "exclusive remedy" clause was evidence that Incline had a right to sue for extracontractual fraud. The "exclusive remedy" clause provided that "[e]xcept as provided in [specified sections], 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."

Incline argued that because the provision stated that contractual indemnification is not the sole and exclusive remedy in the case of fraud, Incline had a right to bring fraud claims. The court instead found that the exclusive remedy provision only provided that in cases of fraud, Incline was not limited to the contractual indemnification provisions, but had other available remedies. The court noted that the exclusive remedy provision did not address the representations that Incline may rely upon to establish a fraud claim, which were expressly addressed in the exclusive representations provision. Thus, the exclusive remedy provision did not reinstate a claim Incline had disclaimed elsewhere in the agreement.

The court also held that Incline had adequately pled claims based on the absence of changes and accounts receivable representations and on the financial statements and undisclosed liabilities representation but only for the periods of time specified in the representations. The director and officer defendants sought to dismiss claims against them individually, but the court held that neither officers nor directors could escape liability if they actively participated in the fraud, even if acting "for the corporation." The officers of the company were communicating with Incline, and the directors were communicating to the officers with the intent that their statements would be repeated to Incline, oversaw the process, actively engaged in the preparation of presentation materials and approved the creation of false sales numbers. Thus the claims against the individual defendants were not dismissed.

The decision gives buyers and sellers useful drafting guidance in how to limit (or avoid limiting) recourse for fraud claims based on extracontractual representations.

Deal Mechanics

1. Halpin v. Riverstone National Inc., C.A. No. 9796-VCG (Del. Ch. Feb. 26, 2015)

The decision highlights the importance of exercising drag-along rights strictly in accordance with their terms if parties want to obtain the intended benefits, such as waiver of appraisal rights.

This decision involved competing motions for summary judgment in an appraisal action and counterclaim following the sale of Riverstone National Inc. (the company) pursuant to a merger agreement. The company's counterclaim was for specific performance by the appraisal petitioners (the minority stockholders) for compliance with the drag-along provisions of a stockholders agreement and waiver of their appraisal rights.

The minority stockholders entered into the stockholders agreement with the company in June 2009. Section 3 of the stockholders agreement set forth a drag-along provision, pursuant to which the company could compel the minority stockholders to tender and/or vote their shares in favor of a change-in-control transaction approved by the majority stockholders. Section 3 provided the following in relevant part (the voting right):

[I]f at any time the Company and/or any Transferring Stockholders propose to enter into any such Change-in-Control transaction, the Company may require the Minority Stockholders to vote in favor of such transaction, where approval of the shareholders is required by law or otherwise sought, by giving the Minority Stockholders notice thereof within the time prescribed by law and the Company's Certificate of Incorporation and By-Laws for giving notice of a meeting of shareholders called for the purpose of approving such transaction.

On May 29, 2014, the company's controlling stockholder provided its written consent for the company to enter into a merger agreement pursuant to which the company would be sold in a reverse triangular merger. The company executed the merger agreement the next day and completed the merger on June 2, 2014. On June 9, 2014, the company sent an information statement to its stockholders informing them of the merger, and attempting to invoke the drag-along provisions and compel compliance with the voting right. The information statement provided that stockholders may be entitled to appraisal rights, but they would only be entitled to the merger consideration if they relinquished the appraisal rights by executing an attached written consent. It also provided that if the stockholders failed to execute the written consent, they would be in breach of the stockholders agreement.

The court first noted that it was a matter of first impression as to whether a common stockholder could waive its statutory appraisal right ex ante. However, the court did not need to resolve that issue because the summary judgment decision would be resolved on other grounds. The court noted that the information statement attempted to invoke the voting right, and that this involved a prospective obligation: the stockholders agreed to vote in favor of a prospective transaction, not consent to a merger that had already been consummated. Therefore, the company was not entitled to specific performance of the drag-along because the drag-along involved a right that was different from the one the company was trying to exercise. The court also rejected the company's claim for specific performance based on the implied covenant of good faith and fair dealing, because that doctrine does not apply with respect to rights that were not contracted but which were foreseeable.

The decision provides useful guidance regarding the exercise of drag-along rights and the need to strictly comply with their terms. It also cautions that while holders of preferred stock can be required to sign prospective waivers of appraisal rights, Delaware courts have not ruled on the enforceability of such waivers as applied to common stock.

2. Lazard Technology Partners LLC v. Qinetiq North America Operations LLC, 114 A.3d 193 (Del. Apr. 23, 2015)

The court ruled that earnout language prohibiting a buyer from taking any action to "divert or defer [revenue] with the intent of reducing or limiting the Earn-Out Payment" bars the buyer from taking action "specifically motivated by a desire to avoid the earn-out" but not action that the buyer merely "knew would have the effect of compromising seller's ability to receive the earn-out".

This decision involved an appeal on behalf of former stockholders (collectively, the seller) of a target company in an earnout dispute arising under a merger agreement. The appellee (the buyer) paid $40 million at closing and agreed to pay up to an additional $40 million under a revenue based earnout provision. When the revenue targets were not achieved, the seller brought an action in the Delaware Court of Chancery for breach of Section 5.4 of the merger agreement, which prohibited the buyer from "tak[ing] any action to divert or defer [revenue] with the intent of reducing or limiting the Earn-Out Payment," and for violation of an implied covenant of good faith and fair dealing.

In a post-trial bench ruling, the Court of Chancery found that Section 5.4 was not breached because the seller had not proven that any business decision of the buyer was motivated by a desire to avoid an earnout payment. The Court of Chancery also rejected the implied covenant claim because, consistent with the language in Section 5.4, the buyer had a duty to refrain from conduct only if it was taken with the intent to reduce or avoid an earnout altogether.

On appeal, the seller argued that Section 5.4 prohibited conduct that the buyer "knew would have the effect of compromising the seller's ability to receive an earn-out." In upholding the Chancery Court's ruling, the Delaware Supreme Court ruled that by its unambiguous terms, Section 5.4 "only limited the buyer from taking action intended to reduce or limit an earnout payment. Intent is a well-understood concept that the Court of Chancery properly applied. The Seller seeks to avoid its own contractual bargain by claiming that Section 5.4 used a knowledge standard, preventing the buyer from taking actions simply because it knew those actions would reduce the likelihood that an earn-out would be due." The Delaware Supreme Court also noted that the Court of Chancery "never said that avoiding the earn-out had to [be] the buyer's sole intent, but properly held that the buyer's action had to be motivated at least in part by that intention."

The Delaware Supreme Court also rejected the seller's argument that the Court of Chancery erred by holding that the implied covenant had to be read consistently with Section 5.4. In upholding the Court of Chancery's ruling that the implied covenant did not inhibit the buyer's conduct unless the buyer acted with the intent to deprive seller of an earnout payment, the Delaware Supreme Court noted that the implied covenant is a cautious doctrine that involves inferring contractual terms to handle developments or contractual gaps, and that the Court of Chancery was "very generous in assuming that the implied covenant of good faith and fair dealing operated at all ... [given] the negotiating history that showed that the seller had sought objective standards for limiting the buyer's conduct but lost at the bargaining table."

The decision serves as a reminder that sellers need to clearly designate in the purchase agreement the standards to which buyers are to be held in earnout provisions. "Knowledge-based" prohibitions on buyer actions need to be specifically written into the contract and will not be implied from "intent-based" prohibitions.

This is part two of a three-part series that originally appeared in Law360 on January 13, 2016.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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