Explore a recent Delaware M&A case where a buyer successfully navigated legal obstacles, including fraud claims, in an asset purchase agreement. Learn about the court’s ruling and the significance of fraud carve-out provisions in M&A transactions.
August 7, 2019
M&A Stories
Introduction:
In the world of mergers and acquisitions, buyers of closely held businesses face limited options when a deal goes sour. Even when fraud is involved, navigating through legal hurdles like indemnification caps, survival periods, and exclusive remedies can be challenging. However, in a recent Delaware case, a buyer successfully overcame these obstacles.
The Deal:
The buyer in this case acquired the seller’s tolling and automated license plate recognition business through an asset purchase agreement dated May 4, 2017. The seller assured in the agreement that there were no significant adverse effects on the business between December 31, 2016, and May 4, 2017.
Additionally, the agreement contained a non-reliance clause, where the buyer explicitly disclaimed reliance on any representations and warranties from the seller, except those within the agreement. There was also an exclusive remedy provision, stating that the buyer’s sole recourse for the seller’s breach of the agreement was limited indemnification, with one exception: fraud claims.
The Lawsuit:
After the deal closed, disputes between the buyer and seller escalated into a lawsuit in Delaware. The buyer accused the seller of fraudulently inducing the purchase by concealing a product development issue related to the business’s new automated license plate recognition camera, which tended to overheat.
The seller responded by moving to dismiss the buyer’s fraud claims, arguing that they were improperly tied to a breach of contract claim.
In response, the buyer argued that the seller had made material misrepresentations and concealed crucial facts about the overheating issue before the agreement was executed, making the fraud claims distinct from any argument about bootstrapping.
The Ruling:
Under Delaware law, a fraud claim can be based on contractual representations. However, when an action relies solely on a breach of the agreement’s terms and not a violation of a separate legal duty, the claim must be pursued as a contract dispute, not a tort.
The court applied Delaware’s bootstrapping doctrine, which prevents a buyer from transforming a breach of the agreement into a fraud claim by alleging that the seller never intended to fulfill its obligations. Simply adding “fraudulently induced” to the complaint isn’t sufficient. Instead, the fraud claim must be based on conduct separate from the agreement breach, such as specific allegations of fraudulent inducement to enter the contract.
In this case, the court found that the buyer’s fraud claim was not improperly bootstrapped to the contract claim. The buyer alleged that the fraud occurred before the agreement was signed when the seller represented no material adverse effects on the business. The buyer didn’t claim that the seller failed to perform under the agreement but rather asserted that the seller misrepresented and concealed a significant product development issue—the camera’s overheating—to induce the purchase. Moreover, the court noted that the buyer sought rescissory damages, a remedy for fraud, not contract breach.
Conclusion:
In summary, the court ruled in favor of the buyer, concluding that they adequately alleged claims of fraudulent inducement and fraudulent concealment. The seller’s motion to dismiss was denied.
Comment:
The inclusion of a fraud carve-out provision, as seen in this case, is common in many M&A transactions. It can be a valuable tool for buyers facing challenging deals, especially when dealing with low indemnification caps and short survival periods.
Case Reference:
3M Company v. Neology, Inc., C.A. No. N18C-07-089 AML CCLD, Superior Court of Delaware, (Decided: June 28, 2019)
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
Check out my book: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles
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