In Agspring Holdco, LLC, et al v. NGP X US Holdings, L.P., et al, the Delaware Court of Chancery (the “Court”) denied a motion to dismiss claims of fraud, aiding and abetting fraud and conspiracy to commit fraud against the CEO and President (the “Executives”) and NGP (defined below), the private equity fund that owned 98% of the equity securities of Agspring LLC (“Agspring”) in connection with the sale of Agspring for $295 million. The complaint alleged that NGP’s goal was to present financial statements that provided NGP with a two times return on its initial $150 million investment. To achieve that goal, the complaint alleges that the plaintiffs fraudulently induced various defendants to enter into equity purchase and loan agreements based upon artificially inflated financial models containing forecasts that were millions of dollars higher than the actual financial model available internally to NGP and Agspring’s executives.
The decision demonstrates that private equity funds can be liable for fraudulent representations and warranties made by its portfolio company in sales agreements and loan agreements even if the private equity fund is not a party to those agreements. This impact can occur if the private equity fund is significantly involved in the sale or loan process or knows or should have known that representations and warranties in these agreements are false when given.
In December 2015, American Infrastructure MLP Funds, a private equity fund, and Agspring LP (together, the “Buyer”), purchased all of the membership interests of Agspring for $295 million. Prior to the sale, NGP X US Holdings, L.P. (“NGP”) owned 98% of Agspring, and Agspring’s President and CEO owned the remaining 2%. In connection with the transaction, two limited liability companies (the “Lender LLCs”) managed by Pacific Investment Management Company loaned Agspring $80 million (the “Term Loan”) pursuant to a Term Loan Agreement and another limited liability company (referred to herein together with the Lender LLCs as the “Investor LLCs”) purchased $45 million of preferred equity of Agspring. When the transaction closed, Agspring projected $33 million of earnings before interest, taxes depreciation and amortization (“EBITDA”) for fiscal year 2016. By the end of fiscal year 2016, Agspring’s actual EBITDA was only $701,900. Buyer later learned that prior to closing the transaction, Agspring had allegedly reduced its 2016 EBITDA forecast internally to $20 million. Agspring continued to deteriorate, and it defaulted on its obligations to the Investor LLCs.
Fraud Claim Based Upon Breach of the Purchase Agreement
The Buyer and Investor LLCs asserted that NGP and the Executives made fraudulent representations in Section 4.15(m) of the purchase agreement, which states in relevant part that “there has not been any . . . Material Adverse Effect” at Agspring since May 31, 2015. The term “Material Adverse Effect” is defined as “any change, circumstance, effect, event, occurrence or condition that, individually or in the aggregate, has had or would reasonably be expected to have a material adverse effect on the Agspring Entities, Agspring Assets or the Business, taken as a whole.”
The definition was subject to a series of exceptions, including that one may not consider “the failure or inability of the Agspring Entities or the Business to meet any projections, forecasts or estimates of revenues or earnings (except to the extent that, with respect to this clause the facts or circumstances giving rise to such failure or inability may themselves be deemed to constitute, or to be taken into account in determining whether there has been a Material Adverse Effect).”
The Court noted that the exception language contained a parenthetical which acknowledged that the facts giving rise to a failure to meet a forecast could themselves be taken into account in determining if a Material Adverse Effect had occurred. On that basis, the Court found that Agspring’s failure to meet its financial forecast and the internal 47% reduction of the EBITDA forecast supported a reasonably conceivable claim that the representations with regard to Material Adverse Effect in Section 4.15(m) of the purchase agreement were false when made.
Fraud and Aiding and Abetting Fraud Claims Based Upon Breach of the Term Loan Agreement
The Investor LLCs asserted that the defendants fraudulently induced them to enter into the Term Loan Agreement and that the Executives and NGP aided and abetted this fraud. NGP and the Executives did not contend that the Investor LLCs failed to adequately plead the elements of fraud. NGP asserted instead that it could not be personally liable even if the complaint’s allegations are proven to be true because NGP is not a party to the Term Loan Agreement.
Aiding and Abetting Claim
The Court stated that the elements of a claim for aiding and abetting fraud are (a) underlying tortious conduct, (b) knowledge and (c) substantial assistance. The Court found that the element was satisfied because the Executives had conceded the viability of the fraud claim against them, and the second element was satisfied because the complaint’s allegations support a reasonable inference that Agspring’s financial results had dramatically declined over the six month period prior to closing necessitating material reductions to its forecast for fiscal year 2016 and imperiling its ability to service its debt after the transaction closed. The third element was found to have been satisfied because NGP appointed Agspring three board members who (i) provided specific feedback to improve Agspring’s financial statements, (ii) encouraged Agspring’s employees to add back amounts to EBITDA and make other modifications to the financial documents and (iii) were in constant communications with the Executives during the sales process and imposed “significant heat” to close the deal.
Underlying Fraud Claim
The Investor LLCs allegations were based upon two representations and warranties by Agspring in the Term Loan Agreement. The first was the representation that the “projections, estimates and pro forma financial information furnished by [Agspring] were prepared in good faith on the basis of assumptions, data, information, tests or conditions believed to be reasonable at the time that such projections, estimates and pro forma financial information were furnished.” The second was the representation that immediately following making the Term Loans, the fair value of Agspring’s assets will exceed its debts.
The Court found that it was reasonably conceivable that Agspring’s default on its Term Loan was the result of fraudulent misrepresentation because (taking the allegations in the complaint as true) the dramatic decline that Agspring had clearly experienced made its debt service unmanageable at the time of closing and necessitated material reductions to its 2016 fiscal year forecast that were not made available to the Investor LLCs.
Civil Conspiracy to Commit Fraud
The Investor LLCs asserted that NGP and the Executives had conspired to fraudulently induce the Investor LLCs to enter into the Term Loan Agreement when they represented that (i) the projections provided by Agspring were prepared in good faith and (ii) Agspring was solvent and its assets would exceed its debt obligations immediately after closing.
The elements for civil conspiracy are (a) a confederation or combination of two or more persons, (b) an unlawful act done in furtherance of the conspiracy and (c) damages resulting from the action of the conspiring parties. Although NGP did not challenge the complaint’s allegations with respect to the second and third elements, NGP argued that the first element was not satisfied.
At the motion to dismiss stage, the Court stated that conspiracy could be inferred from the behavior in the complaint. The Court then found that the complaint stated a claim for civil conspiracy against NGP because (a) the facts in the complaint support a reasonable inference that representatives of NGP worked closely with the Executives throughout the sales process with the purpose of getting a deal done with the Buyer at the valuation that NGP desired, including negotiating two price reductions directly with the Buyer and encouraging Agspring employees to add back amounts to the EBITDA calculations and make other adjustments to the financial documents that were later disclosed to investors to make Agspring look more attractive to potential investors and (b) NGP was aware of the internal reductions to Agspring’s fiscal year 2016 EBITDA forecasts that the Executives concealed from the Buyer while providing inflated projections.
- A well drafted disclaimer of reliance on statements outside the contract can prevent fraud claims which are based on statements that are outside of the “four corners” of the contract; however, Agspring demonstrates that contractual representations and warranties themselves may give rise to fraud claims.
- A private equity fund seller may be liable for fraudulent representations and warranties that are made by its portfolio company even if the private equity fund is not a party to that agreement. This liability can be imposed if the private equity fund is substantively involved in the sales process or negotiation of the sales or loan agreements or if the private equity fund knew or should have known that representations and warranties in these agreements were false when given.