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Court Finds Fraud Carve Out Ambiguous in Stock Purchase Agreement

by   |   May 4, 2017

In EMSI Acquisition, Inc., v. Contrarian Funds, LLC et al, the Delaware Court of Chancery examined a fraud carve out from an indemnification cap and an action for confirmation of an auditors award on a purchase price adjustment.

The Plaintiff alleged the Company’s financial statements were manipulated. The Sellers were mostly non-management personnel that did not participate in the business. The Sellers and the Company clearly disclaimed making any other warranties other than those set forth in the Stock Purchase Agreement.  The SPA included a non-reliance clause where the Buyer represented that it was only relying on the promises and representations contained in the SPA.

Section 10.4(d) of the Stock Purchase Agreement provided a cap on indemnification claims by stating “[n]otwithstanding anything to the contrary in this Agreement”:

The Buyer Indemnified Parties shall only be entitled to indemnification (i) with respect to Losses in respect of the representations and warranties (other than the Excluded Representations and the Specific Indemnity Items) to the extent of, and exclusively from, any then remaining Escrow Funds . . .

The excusive remedies section of the SPA included the following carve out in Section 10.10(b):

Notwithstanding anything in this Agreement to the contrary (including . . . any limitations on remedies or recoveries . . .) nothing in this Agreement (or elsewhere) shall limit or restrict (i) any Indemnified Party’s rights or ability to maintain or recover any amounts in connection with any action or claim based upon fraud in connection with the transactions contemplated hereby . . .

On a motion to dismiss, the Court was faced with determining whether the two competing “Notwithstanding” sections were plain and unambiguous. The Court stated the Plaintiff did not seek to avoid the non-reliance clause by bringing a claim for fraud based on extracontractual representations.

Defendants claimed the Plaintiff had two choices: (1) suing contractually and going through the indemnification provisions or (2) suing for fraud. The Defendants believed the wording made clear that “[i]f the Company’s managers intentionally misrepresented facts to the Buyer without knowledge of falsity by the Seller, then the Buyer . . . must proceed with an Indemnity Claim subject to the Indemnity Fund’s liability cap.”

The Plaintiff argued that the SPA allowed the Buyer, without limitation or restriction, “to recover any amounts in connection with any action or claim ‘based upon fraud’ in connection with the contemplated transaction.” Plaintiff contended that, in this respect, the SPA deliberately “allocated to Sellers the risk that the Company was knowingly misrepresenting itself when it entered into the SPA” and that its claim was not subject to the limitations on recovery imposed by Section 10.4.  Plaintiff claimed this was true even if it has not pled and cannot prove that the Sellers acted with scienter in connection with their own representations and warranties or knew that the Company’s representations and warranties were false when made.

Referring to the dispute as resulting from “inelegant drafting,” the Court determined it could not grant the motion to dismiss because the Buyer’s interpretation was reasonable, and may or may not ultimately be the most reasonable after considering extrinsic evidence.

In accordance with the SPA, the parties had also initiated a so called “net working capital adjustment process” which required a determination by a “Settlement Auditor.” Defendants disputed certain adjustments made by the Settlement Auditor.  In the second count in the Complaint, the Plaintiff sought confirmation of the finding of the Settlement Auditor as an arbitration award pursuant to a Delaware statute.  The Court dismissed the claim because the SPA did not include a clear expression of intent to arbitrate.  The reason was the SPA stated the Settlement Auditor would resolve disputes “acting as an expert and not an arbitrator.”