Background

The dispute arose from a securities purchase agreement (“SPA”) pursuant to which buyer Bracket Holding Corp., a holding company formed by private equity firm Parthenon Capital Partners, LP, agreed to purchase three pharmaceutical research and development businesses from seller United BioSource LLC, a subsidiary of Express Scripts, Inc., for US$187 million. The purchase price was based on a multiple of the seller’s EBITDA, which the seller represented in the SPA was true and correct. After closing, however, the buyer determined that the seller had inflated historical revenue by millions of dollars, and that as a result it had overpaid for the companies by tens of millions of dollars based on the effect that large unbilled receivables had on revenue.

The SPA provided for an indemnification regime in which the remedy for breach by the seller of its representations and warranties was limited to recovery under a representations and warranties insurance policy, with carveouts for breach of fundamental representations (not at issue in the case here) and for “deliberate” fraud. The term “deliberate” was not defined in the SPA. The buyer was awarded US$13 million under the insurance policy in an arbitration against the insurer, in which the seller was not a party. The buyer then filed suit in the Delaware Superior Court, alleging fraud on the part of the seller that entitled it to recover its damages beyond the limit of the insurance policy.

In light of the contractual limitation in the SPA, the buyer could recover directly from the seller its damages in excess of the limits of the insurance policy only for seller’s “deliberate” fraud. Under Delaware common law, the term “fraud” includes both actual knowledge of a misrepresentation and the making of a misrepresentation with reckless disregard for its truth or falsity. Applying this common-law definition, the trial court instructed the jury that it should find in favor of the buyer if it were to find that the seller had made false representations or warranties either with actual knowledge or recklessly. The seller objected to that jury instruction, arguing that the parties agreed in the SPA that the buyer’s sole and exclusive remedy for breach of non-fundamental representations and warranties was recovery under the insurance policy, except in the case of “deliberate” fraud. The seller argued that “deliberate” fraud is narrower than the common-law definition, and reaches only intentional conduct—not recklessness. The trial court repeatedly overruled the seller’s objection,² and the jury returned an US$82 million verdict in favor of the buyer.

An onslaught of post-trial and appellate briefing ensued, with the trial court ultimately ruling against the seller’s motion for a new trial.³ Although numerous issues were briefed on appeal, the Supreme Court ruled that the trial court’s erroneous jury instruction alone required reversal and a new trial.

Supreme Court Decision

The Supreme Court’s opinion focused on the tension between the bedrock principle of Delaware law that sophisticated parties should be allowed to exercise freedom of contract, on the one hand, and Delaware’s “distaste for immunizing fraud,” on the other. To strike the appropriate balance, the Court turned to the Court of Chancery’s seminal decision in ABRY Partners V, L.P. v. F & W Acquisition LLC,⁴ which permitted sophisticated parties to disclaim fraud claims based on representations or promises not contained in the contract itself. The decision in ABRY explained that while, “as a matter of public policy,”⁵ a party cannot limit its exposure “for its own conscious participation in the communication of lies to the buyer…,” the counterparty could “knowingly accept[] the risk” that representations may have been made in “a reckless, grossly negligent, or negligent manner.”⁶

The Supreme Court adopted this standard as the appropriate balancing of Delaware’s interest in freedom of contract and its public policy against immunizing fraud for contractual representations. The Court further held that the SPA implemented this balance, with the parties agreeing that the buyer accepted the risk that the seller made the representations in the SPA with reckless disregard for their accuracy. The Court was unmoved by the lack of a definition for the term “deliberate fraud” in the SPA. Rather, the Court held that the modifier “deliberate” required “an intentional state of mind” to avoid the limitation of liability. Because it determined that such an intentional state of mind “is a different kettle of fish than a reckless one,” liability beyond the insurance policy could not be premised on reckless conduct alone, mandating reversal of the US$82 million jury verdict in favor of buyer.

Takeaway

The decision in Express Scripts affirms that buyers and sellers can allocate the risk of an element of fraud, i.e., recklessness, to the buyer, while leaving the remaining risk, i.e., intentional misconduct, with the seller. In so doing, the decision highlights that the term “fraud,” without more, includes recklessness. By the same token, the parties can manifest their intent to limit a seller’s liability only to intentional misrepresentations in the contract without a detailed, customized definition.