A private equity investor’s purpose in life is to generate superior returns for limited partners and to share a portion of those returns. It’s that simple. Accordingly, the main event for any private equity investment, the culmination of a long and labor intensive process involving many flights, many meetings, many negotiation sessions and many conference calls, is the liquidity event. Here the investor realizes and locks in the gain his or her efforts have generated, creating happy limited partners and a distribution of carry. Unless, of course, a buyer discovers that the company it bought isn’t what it was purported to be and brings litigation to take back the seller’s gains.
Recent cases involving year 2000 and 2001 acquisitions are reminders that the private equity investment process does not end at the time of a liquidity event. Rather, it ends only when the gains are safe from recapture. The opinions in these cases also underscore the difficulty of crafting provisions, no matter how carefully drafted, that will insulate a seller from fraud-based claims of a disappointed buyer.
The first case, Merrill Lynch & Co., Inc. (“Merrill”) vs. Allegheny Energy, Inc. (“Allegheny”), involved the purchase by Allegheny of Global Energy Markets (“GEM”), an energy-commodities trading business owned by Merrill, for $490 million plus a 2% retained interest. Initially, Merrill was Allegheny’s investment banker, but after the sale process began Merrill withdrew from this role after suggesting that Allegheny buy GEM. Shortly after the closing, Allegheny discovered a number of allegedly fraudulent trades by GEM, including trades with Merrill’s client Enron. Allegheny alleged these “wash,” “round trip” and other “sham” energy trades artificially inflated GEM’s trading volume and revenue. Allegheny also alleged Merrill knew that GEM’s management had engaged in “highly questionable if not outright criminal business practices.” Allegheny sought to rescind the transaction based on a claim of fraudulent inducement, among others. In making this claim, Allegheny alleged facts that included the improper trades and repeated presentations by Merrill regarding GEM’s potential for growth, internal control mechanisms, risk-management systems and management team that painted a picture that was rosier than reality.
Merrill sought to dismiss the case and relied for its defense on a confidentiality agreement executed at the beginning of the negotiations that disclaimed legal responsibility of the seller for any information, for example the Merrill presentations, that was not covered by the representations and warranties in the definitive agreement. (“[N]either party makes any representation or warranty as to the accuracy or completeness of the Evaluation Material and…only those representations and warranties made in the definitive agreement, if any, shall have any legal effect.”) The buyer also agreed in the definitive agreement to an integration clause (which provided that the definitive agreement and the confidentiality agreement superseded all prior discussions) and a disclaimer of reliance on any representations other than those set forth in specific sections of the definitive agreement. In essence, Merrill argued that Allegheny relied at its peril on any information provided to it that was not covered by representations and warranties in the definitive agreement, i.e., information in the data room and the management presentations. The agreement, however, also contained a representation to the effect that the information provided by Merrill included all of the information known to Merrill “which, in [the seller’s] reasonable judgment exercised in good faith, is appropriate for [the buyer] to evaluate the trading position and operations” of the GEM energy business.
The federal court in the Southern District of New York didn’t buy Merrill’s defenses. Perhaps influenced by factors such as the Enron relationship and Merrill’s prior role as Allegheny’s investment banker, and noting the absence of a reference to the concept of reliance in the confidentiality agreement, the court ruled that “a disclaimer is generally enforceable only if it tracks the substance of the alleged misrepresentation.” In other words, a general, non-specific disclaimer and a relatively standard package of contractual protections including an integration clause weren’t a sufficient defense, particularly with respect to matters uniquely within Merrill’s knowledge. While as a general matter a party who specifically disclaims reliance on representations in a contract cannot later allege it was fraudulently induced to enter the contract by the disclaimed representations, in this case the absence of narrowly targeted disclaimers, i.e., specifically related to the Enron relationship, the qualifications of GEM management and even the wash trades, doomed the Merrill defense. The Court denied virtually all of Merrill’s motion to dismiss the case, raising the possibility of a costly, lengthy and unpredictable trial.
The 2003 decision of the Delaware Chancery court in Glouster Holding Corp. vs. U.S. Tape and Sticky Products, LLC reached a similar result. In that case the aggrieved buyer raised counterclaims against the seller for failing to disclose various matters, including environmental problems, uncollectible accounts receivable and hidden payables, based on theories of fraud and breach of representations and warranties, among others. As in the Merrill case, the seller based its defense on a disclaimer of liability for evaluation material in the confidentiality agreement and provisions in the definitive agreement including a sole remedy provision, an integration clause and a provision to the effect that the assets were conveyed “where is as is with no express or implied warranties as to use, fitness, condition or otherwise.” Applying Massachusetts law, the court denied the seller’s motion to dismiss the case, sending it to trial. In so doing the court rejected the notion that provisions such as those used by the seller, including the integration clause, were sufficient to create an automatic defense to a fraud claim.
The sellers in these cases may have asked, “What went wrong?” Can a seller ever fully insulate itself from post-closing claims? The recent cases cast doubt on the efficacy of customary defenses, no matter how carefully crafted. Nonetheless, a number of steps can be suggested for a seller seeking to prevent post-closing claims, and particularly claims that are not well grounded or even frivolous.
* Tell the truth. There is no better defense against a fraud claim than to avoid fraud or the appearance of it, and to provide full information to the buyer. It will save pain later and can also elevate the overall tone of the negotiations.
* Continue to use the full panoply of contractual provisions, e.g., sole remedy provisions, limitation of representations to those in the definitive agreement, integration clauses, etc. Most significantly, consider using specific rather than general disclaimers. In this regard, the practice that has emerged with respect to forward looking disclosure language in public disclosure documents (and in many material adverse change/effect clauses) may provide useful guidance.
* Select the governing law carefully. While governing law and forum clauses often are viewed as legal boilerplate, they can be outcome determinative.
* Avoid or limit general 10b-5-like representations whenever possible.
* Remember that confidentiality agreement provisions are important and often have been central in post-closing litigation. Review the language carefully and emphasize the concept of non-reliance.
A buyer of course will have a different perspective and will never want to relinquish fraud claims, both as a matter of economics and as a matter of justice. For the right price, however, a buyer may be willing to definitively limit or waive post-closing recourse, as buyers of public companies routinely do. Here the challenge to the parties is to create contractual provisions that will ensure this result occurs when the parties have agreed to it as a business matter.
While private equity investors like nothing more than profitable exit events, they like nothing less than costly and distracting post-closing litigation seeking to claw back their profits. Recent court decisions would appear to expand the possibility of buyers successfully pursuing such litigation. These decisions suggest that renewed focus on standard contractual language is appropriate for sellers who want to hold on to the gains their efforts have created.
Addendum: Can you sue if you knew?
“Knowledge” is a concept that often receives much attention in the negotiation of an acquisition transaction. One way sellers seek to prevent buyers from bringing post-closing claims involves the use of a contractual provision that bars any claim if the matter or problem involved was “known” to the buyer prior to closing. It is unfair, sellers argue, for a buyer to withhold negative information it has discovered in its due diligence and then “jump” or “sandbag” the seller after closing.
As a commercial matter, buyers object to “anti-sandbagging” provisions because they may force them to prove a negative, i.e., that they didn’t know something, depending on who has the burden of proof. This shifts the focus in litigation from whether a representation was false to a debate over whether the buyer knew or should have known that it was false. Buyers also object to “anti-sandbagging” provisions because sellers always have superior knowledge of the asset being sold; they fear that sellers will interpose an “anti-sandbagging” provision to undermine a carefully negotiated indemnification package. Ultimately, sophisticated sellers may ask for but usually do not insist on this type of provision in negotiating definitive agreements because they understand that it would be commercially irrational for a buyer to wire funds despite knowledge of a problem in the hope it will later obtain relief through a time-consuming indemnity claim. A well drafted acquisition agreement usually addresses this matter through simple survival and reservation of rights provisions coupled with precise limits on the extent of recovery that can occur.
About the Authors: John LeClaire is chair of the Private Equity Group of Goodwin Procter LLP. He can be reached for comment at firstname.lastname@example.org. Michael Kendall is a corporate partner and member of the Private Equity Group of Goodwin Procter LLP and can be reached for comments at email@example.com