Bootstrapping Doctrine No Bar to Business Buyer’s Fraud Claim

Introduction

A buyer of a closely held business often has limited recourse against a seller if the deal turns out bad.  Even if fraud is involved, the buyer must run the gauntlet of indemnification cap, survival period, exclusive remedy, non-reliance, and integration provisions. The buyer in this Delaware case ran the gauntlet and survived a motion to dismiss.

The deal

Our buyer purchased the seller’s tolling and automated license plate recognition business pursuant to an asset purchase agreement executed on May 4, 2017. The seller represented in the APA that there had been no material adverse effect to the business between December 31, 2016 and May 4, 2017.

Elsewhere in the APA, the buyer, in a non-reliance provision, expressly disclaimed reliance on any seller representations and warranties except those contained in the APA. There was an exclusive remedy provision where the buyer agreed that it’s exclusive remedy for seller’s breach of the APA was the limited indemnification remedy provided for in the APA. However, the exclusive remedy provision did not apply to buyer fraud claims (the fraud carve-out provision).

The lawsuit

The buyer and seller had a falling out after the closing which boiled over into a Delaware lawsuit. The buyer accused the seller, among other claims, of fraudulently inducing the buyer into purchasing the business by concealing a product development overheating issue with the business’s new fixed automated license plate recognition camera.

The seller filed a motion to dismiss the buyer’s fraud claims, arguing that the fraud claims were impermissibly bootstrapped to the buyer’s breach of contract claim.

In response, the buyer said that it had alleged the seller made material misrepresentations and concealed material facts about the overheating issue before the APA was executed, which brought the fraud claims outside any argument regarding bootstrapping.

The court said that under Delaware law, a fraud claim may be based on contractual representations, but where an action is based entirely on a breach of the terms of the APA, and not on a violation of an independent duty imposed by law, the buyer must sue in contract and not in tort.

And under Delaware’s bootstrapping doctrine, the buyer may not bootstrap a claim of breach of the APA into a claim for fraud by alleging that the seller never intended to perform its obligations. Merely adding the term “fraudulently induced” to the complaint is not enough. Instead, the buyer must base its fraud claim on seller conduct that is separate and distinct from the conduct constituting an APA breach; such as allegations specifically suggesting fraudulent inducement to contract.

Here, the court concluded that the buyer’s fraud claim was not impermissibly bootstrapped to its contract claim. The buyer specifically alleged the fraud occurred before the buyer and seller entered the APA, when the seller represented there was no material adverse effect to the business. The buyer did not allege the seller failed to perform under the APA, rather, the buyer made a separate and distinct claim that the seller misrepresented and concealed a major product line’s development issue, the overheating of the camera, in order to induce the buyer into purchasing the business. Further, the court noted that the buyer seeks rescissory damages, which is a remedy for fraud, not breach of the APA.

Bottom line: the court held that the buyer sufficiently pleaded claims for fraudulent inducement and fraudulent concealment; and denied the seller’s motion to dismiss.

This case is referred to 3M Company v. Neology, Inc., C.A. No. N18C-07-089 AML CCLD, Superior Court of Delaware, (Decided: June 28, 2019)

Comment 

The deal’s fraud carve-out provision is used in many transactions. It can help a buyer with a problem transaction that would otherwise be handicapped by a low indemnification cap and short survival period.

By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

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Posted in bootstrapping doctrine, exclusive remedy, fraud carveout, fraud in business sale, non-reliance clause Tagged with:

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