[co-author: Melissa Bales, Senior Law Clerk]
On February 23, 2021, the Delaware Supreme Court determined that, when parties to a securities purchase agreement unambiguously distinguish between deliberate fraud and other states of mind and conduct, the former is limited to intentional fraud and does not include recklessness. As a result, under the limitations to the indemnification provisions contained in the securities purchase agreement, buyer’s exclusive remedy for breaches of seller’s representations—which, while falsely made, involved conduct less egregious than deliberate fraud—was limited to recovery under a representations and warranties insurance policy (R&W Policy).
In Express Scripts v. Bracket Holdings Corp., Express Scripts Inc., through its subsidiary United BioSource LLC, sold three of its pharmaceutical research and development businesses to Bracket Holdings Corp., a holding company of Parthenon Capital Partners LP, for $187 million. In pricing the transaction, Parthenon focused on a multiple to the acquired companies’ EBITDA in the 12-month period prior to closing (TTM EBIDTA). In the securities purchase agreement, United BioSource represented that the financial information in the disclosure schedule supporting a TTM EBITDA of $29 million was true and correct. The purchase agreement provided that United BioSource would not be liable for any breach of the purchase agreement’s representations and warranties, other than the fundamental representations or where the representation was fraudulently made. Moreover, the purchase agreement provided that, absent deliberate fraud, Bracket’s exclusive remedy against United BioSource was the R&W Policy. Specifically, the purchase agreement provided in part: “EXCEPT IN THE CASE OF ANY DELIBERANT [SIC] FRAUDULENT (I) ACT, (II) STATEMENT, OR (III) OMISSION … THE SOLE AND EXCLUSIVE REMEDY OF [BUYER] WITH RESPECT TO ANY BREACH BY [SELLER] OF ANY REPRESENTATION OR WARRANTY … CONTAINED IN THIS AGREEMENT SHALL BE SATISFIED SOLELY FROM THE [R&W POLICY]. The purchase agreement did not define “deliberate” or “fraud.”
After closing, buyer claimed that seller and its parent had engaged in fraud by inflating the revenue and working capital of one of the divisions of the acquired companies by millions of dollars because seller had inflated historical revenues through unbilled receivables. In an arbitration proceeding, buyer recovered $13 million under the R&W Policy for breach of seller’s representations and warranties in the purchase agreement. Separately, an arbiter under the working capital arbitration provision in the purchase agreement found that the final working capital entitled buyer to an adjustment of $504,591 (and not the more than $25 million buyer had sought). Buyer then sued seller, its parent, and seller’s vice president of finance in Delaware Superior Court for fraudulently inducing buyer to purchase the acquired companies and claimed that such fraud entitled it to recover damages beyond the limit of the R&W Policy. After a 10-day trial, the jury found that seller had indeed committed fraud and awarded Bracket $82.1 million in damages, which award was appealed to the Delaware Supreme Court.
The Supreme Court reversed the Superior Court and remanded the case for a new trial based on an erroneous jury instruction that the jury could find seller liable to buyer not only for deliberate fraud but also for recklessness.
The Supreme Court cited ABRY Partners V, L.P. v. F & W Acquisition LLC, in which the Court of Chancery recognized that, while contracts may not insulate a party from damages from a party’s fraudulent conduct, there is a strong tradition in Delaware of having commercial laws that are efficient. The ABRY court resolved that tension by finding that, while Delaware common law fraud includes recklessness, when a party knowingly accepts the risk that their counterparty will act with “inadequate deliberation,” then that party cannot escape their agreed-to contractual limitations on liability by attempting to show that the counterparty acted in a reckless, grossly negligent or negligent manner. Referencing ABRY and Black’s Law Dictionary, the Supreme Court in Express Scripts concluded that the purchase agreement provided unambiguously that, except in the case of deliberate fraud and certain fundamental representations, buyer could only recover up to the R&W Policy limits for breaches of seller’s representations and warranties, and that “deliberate” fraud, even though left undefined in the purchase agreement, included only deliberate or intentional misrepresentations and not recklessly indifferent conduct.
Some lessons can be gleaned from the Express Scripts decision:
First, undefined fraud carve-outs from indemnification provisions can lead to claims based on constructive knowledge or reckless conduct and other mental states. Sellers can effectively limit liability with a provision that narrowly defines the state of mind necessary to constitute “fraud.”
More generally, buyers and sellers should carefully consider how to allocate risks associated with post-closing disputes and what should be excepted from the limitations to the indemnification and exclusive remedy provisions. Clear drafting is critical. Parties should consider specifically defining not only the nature of the conduct that is and is not intended to be covered by any “fraud” exception, but also whose fraud is being carved out.