Insight Center: Publications

A 'Magic Perspective' on Fraud by Sellers in Private Equity Deals

Authors: James D. Epstein and Jeremy I. Levy

A 'Magic Perspective' on Fraud by Sellers in Private Equity Deals

With claims on the rise, getting the language right in sales documents is more important than ever

TheDeal.com (ISSN 1547-7584) is published by The Deal. © Copyright 2016 The Deal. The Copyright Act of 1976 prohibits the reproduction by any means of any portion of this publication except with the permission of the publisher.

An auction for a private equity portfolio company heats up. Bidding intensifies. The offer price soars. One bidder, another PE firm, finally prevails.

At that point, almost everyone involved exhales, celebrates — or licks wounds — and moves on. But for lawyers on both sides, who must sit down and hammer out a purchase agreement, there's much more work to be done and many more obstacles to overcome. One of most challenging and contentious: Defining what constitutes potential fraud on the part of a seller.

James Epstein, a Philadelphia-based partner in the commercial department of Pepper Hamilton LLP, faced that challenge in a recent transaction. "We probably spent more time on this issue than we spent on any other single issue," he says.

Don't dismiss the problem as just lawyerly complexity. The stakes can be enormous. That's true both in terms of potential judgments and in legal costs. It's extremely difficult to get a judge to summarily dismiss a suit, which can often drag on for years and involve resource-heavy discovery. Allegations of deal-related fraud appear to be on the rise. PE firms are becoming more and more attuned to the importance of defining fraud, protecting against a possible fraud, or insulating against allegations of fraud. "That education process has to take place," Epstein says. lt "isn't just about liability exposure, it's also about the litigation process and the costs of litigation."

It's extremely difficult to get a judge to summarily dismiss a suit, which can often drag on for years and involve resource-heavy discovery

What's more, the law is still evolving and not necessarily in one direction. Each successive court case refines what kinds of statements and documents can form the basis of fraud and how their acknowledgement should be drafted in contracts. But when it comes to "what is fraud and what can you do to limit it, it's still unclear," says Jeremy Levy, an associate in Pepper Hamilton's corporate and securities practice group, based in Berwyn, Pa.

A continued uncertainty prevails despite — or perhaps because of — two recent decisions on the issue. They deal with such esoteric concepts as "magic words" statements, preferably sanctioned by case law, that disclaim any reliance on what may have been said outside the contract. They emphasize that the buyer must explicitly acknowledge what the seller has asserted in terms of the company being sold, its value and the documentation that supports those assertions — what in legal parlance is called reps and warranties.

The need for that kind of meticulous drafting is becoming more and more important if sellers wish to limit liability. However, "there has been some clarity [as well] around the fact that intentional fraud is something you cannot contract away," Epstein says.

In 2006, Delaware Chancery Court Judge Leo Strine issued what is widely considered the seminal ruling on corporate fraud and indemnification against it. In ABRY Partners V LP v F&W Acquisition LLC, Strine ruled that "when a seller lies," monetary caps on liability and limits on indemnification no longer hold.

The case involved two PE firms. ABRY paid Providence Equity Partners about $500 million for portfolio company F&W Publications, acquired in an auction. Several months after closing and gaining control of F&W, ABRY demanded to rescind the purchase. lt then sued, claiming that both F&W management and Providence had purposely manipulated financial statements, in effect increasing the value of F&W by $100 million. The sale documents limited recourse to 4 percent of the total sale price, or just $20 million.

In the crux of his decision, Strine cited public policy when he wrote that an intentional lie — as opposed to an unintentional misrepresentation of fact — trumps any contract limiting recourse, even between the most sophisticated buyers and sellers.

Strine also distinguished between a parent with active knowledge and involvement in the portfolio company and one in which the owner is completely hands-off. And he famously added: "Parties can protect themselves against unfounded fraud claims through explicit anti-reliance language. If parties fail to include unambiguous anti-reliance language, they will not be able to escape responsibility for their own fraudulent representations made outside the agreement's four corners," that is, the contract.

Just be as broad as possible and just use the word 'fraud'

In the years since, "courts have picked away at that [definition] and said there are other kinds of fraud out there that are not necessarily up to that particular high standard," explains Epstein, but which can still result in liabilities that exceed the stated cap, often 10 percent of the deal value, and insurance that might cover the cap.

All that comes as deal lawyers on the sell-side attempt to structure acquisition contracts in such a way that specifically delineates the limits on fraud claims. Meanwhile, their buy-side counterparts try to keep definitions general and attempt to exclude fraud from any cap on liability. "Just be as broad as possible and just use the word 'fraud'," Epstein counsels.

Critically, lawyers on both sides these days will draft whole paragraphs that acknowledge what reps and warranties are included in the agreement. Lawyers for sellers attempt to state in the clearest language possible that fraud claims can't be made on the basis of anything external to the contract.

Lawyers for buyers, Levy says, must get their clients to determine what statements made by the sellers are critical to the underlying business thesis. Those statements must be included in the reps and warranties.

"There must be something in the contract that can be a hook that we can point to and say that since that statement is false, we can sue for fraud," Levy explains.

"There is this thinking now that you have to be very specific about who is saying what, when and how in regards to these acknowledgements," Epstein says.

According to Epstein, Delaware chancery courts have ruled that there are "very specific requirements" on who sets out all the reps and warranties. "Otherwise, those acknowledgements are not applicable and won't be enforced," he says.

Two recent cases delve into that process. Last November, Delaware Chancery Court Judge Travis Laster ruled on a legal fight between Prairie Capital and Incline Capital Partners over Prairie's $27 million sale in 2012 of a portfolio manufacturing company called Double E. Laster found that Double E, with the knowledge of Prairie Capital, had falsified sales to ensure the deal would consummate in time.

However, the agreement specifically said that claims of fraud based on misrepresentations outside the contract weren't allowed, and that the buyer acknowledged this, adding that it had conducted independent due diligence in reaching its decision. The judge agreed that the exclusive representations clause held and dismissed Incline's fraud claims.

The other case was FdG Logistics LLC v A&R Logistics Holdings Inc., with a ruling made in February. The case involved the 2012 sale by majority owner FdG Associates and others of a trucking company to PE firm Mason Wells. In a subsequent lawsuit, the buyer alleged fraud. The seller responded that the fraud claim was based on statements outside the contract. In that case, however, Delaware Chancery Court Judge Andre Bouchard ruled that the acquisition agreement didn't contain what the court termed an "affirmative disclaimer of reliance" by the buyer and ruled, at least in this matter, in favor of the buyer. Judge Bouchard acknowledged that the contract did not require "magic words" but the words do have to be written from the buyer's perspective.

The lesson here, Levy says, is for a seller to "make sure fraud claims can only be based on reps and warranties in the contract." To do so, a lawyer is best served by using both magic words and the magic perspective: "[the lawyer] can simply copy and paste from Prairie Capital and put it in the buyer's representations section, and then [the lawyer has] achieved that objective."

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

Data protection laws have changed, so we have revised our Privacy Policy.