Treatment of fraud is a key issue in M&A transactions and often a heavily negotiated point. Acquisition agreements often include “fraud carve-outs” – exclusions for fraud from highly negotiated limitations as to survival of representations and warranties and seller indemnification obligations (e.g. caps, baskets, etc.). As fraud claims have been frequently litigated over the years, many M&A practitioners have moved to defining fraud in the acquisition agreement to clearly establish what both parties consider to be “fraud.” The main considerations for buyers and sellers are (1) what exactly is deemed to be fraud and (2) what is the scope of statements for which fraud can be alleged. The purpose of this Practice Brief is to explain generally why these considerations regarding fraud should matter to both buyers and sellers.
What is fraud?
General common law fraud is a false statement of a material fact that the person making the statement knew was false and on which the person making the statement intended the other person to rely, which was justifiably relied on by the other person, and which injured the other person. Courts, however, have interpreted what it means to “know” that a statement is false to include statements that are made recklessly without sufficient efforts to determine whether the statement is true or false and misrepresentations that were made unintentionally. Consider, if the CEO of a target company makes a false statement about the company’s top customers that she does not know to be false, but she failed to ask the company’s head of customer accounts, who knew that the statement was false, is that fraud? What if the CEO had an unread email in her inbox from the head of customer accounts that, if read, would have given the CEO actual knowledge that her statement was false? The actual facts in a case when fraud is litigated are usually much more complex, so it is easy to see how the term “fraud” can be unclear if not specifically defined in the acquisition agreement. As a buyer, it is typically beneficial to rely on the common law definition of fraud or to define fraud broadly to include false statements made recklessly. As a seller, it is important to limit fraud to an intentional statement that is made with knowledge of its falsity.
What are statements for which there could be fraud?
In the context of an acquisition, sellers make many statements and provide a lot of information to the buyer – through management calls and meetings, integration calls and meetings, the provision of company information in a data room, written and oral responses to due diligence questions, and the specific representations and warranties in the acquisition agreement. All of these statements could potentially give rise to a fraud claim unless the parties limit the scope of actionable fraud for purposes of the acquisition agreement. Sellers want to limit the statements that could give rise to a fraud claim to the representations and warranties made in the acquisition agreement, while buyers want to be able to rely on statements and materials provided as part of the entire due diligence process.
The agreement that parties reach with respect to fraud will depend on a variety of factors – relative bargaining power, location (European-style transactions generally differ from U.S.-style transactions), makeup of the target’s shareholder base, overall indemnification structure – and will be negotiated differently in each transaction, but it is important to understand the impact that fraud may have on a buyer’s ability to recover damages and a seller’s risk of losing proceeds following closing.