Chancery Court Cites Inelegant Drafting When Allowing an Indemnification Claim to Proceed

By Whitney Smith and Dean Brazier

In EMSI Acquisition, Inc. v. Contrarian Funds, LLC, et al., C.A. No. 12648-VCS (Del. Ch. May 3, 2017) the Delaware Chancery Court denied a motion to dismiss brought by defendants who were sellers (“Sellers”) in the acquisition of EMSI Holding Company (“EMSI”) by an affiliate of private equity firm Beecken Petty O’Keefe & Company where “inelegant drafting” created an ambiguity that may make the Sellers liable for EMSI’s fraudulent representations and warranties.  To reach this conclusion, the Court considered whether the provisions of the Stock Purchase Agreement (“SPA”) permitted the plaintiff (“Buyer”) to seek indemnification beyond the cap on liability and, if so, whether the Sellers could be liable for the allegedly fraudulent representations and warranties from EMSI.  The Court concluded that the SPA contained conflicting provisions with interpretations that could reasonably support either party’s claims and the conflicts could not be resolved on a motion to dismiss.

The Buyer sought to recover losses incurred when it acquired EMSI following a forensic investigation initiated by Buyer. The Buyer alleged that fraudulent accounting practices caused the Buyer to pay more for EMSI than it was actually worth. The SPA contained two mechanisms for the Buyer to recover such losses: a post-closing net working capital adjustment provision and indemnification for breaches of representations and warranties.  Both mechanisms, however, were capped at an escrow amount of approximately $9.6 million (“Escrow Cap”), which was exceeded after the parties completed the post-closing net working capital dispute process.  The Buyer brought this action making two arguments for why the Escrow Cap should not apply and it should be fully compensated for the losses incurred.  First, the Buyer argued that it should be fully indemnified, beyond the Escrow Cap, because the indemnification provisions of the SPA contained a broad exception for claims based upon fraud.  Second, the Buyer argued that it should be allowed to recover the excess of the net working capital determination over the Escrow Cap because the valuation determined by an independent auditor was an arbitration award that should be “confirmed,” and made binding on the Sellers, under the Delaware Arbitration Act.

The Court defined the two claims as (i) “whether [the Buyer] may avoid contractual limits on recovery for indemnification claims against the Sellers when the claims are based on fraudulent representations in the SPA made by [EMSI],” and (ii) “whether findings of an independent auditor who attempted to resolve the dispute between the parties post-closing may be ‘confirmed’ by the Court under the Delaware Arbitration Act.” The Sellers moved to dismiss both claims. The Court denied the motion for the first claim but granted the motion for the second claim.

The indemnification provisions of the SPA contained both a cap on damages for breaches of the representations and warranties and an exclusive remedies provision. Specifically, Section 10.4(d) capped damages recoverable by the Buyer: “Notwithstanding anything to the contrary in this [SPA], . . . the Buyer Indemnified Parties shall only be entitled to be indemnification . . . in respect of the representations and warranties . . . to the extent of, and exclusively from, any then-remaining Escrow Funds” (emphasis added).  The exclusive remedies provision, however, contained an important carve out for claims based on fraud.  Specifically, Section 10.10(b) provided: “Notwithstanding anything in this [SPA] to the contrary (including . . . any limitations on remedies or recoveries . . .) nothing in this [SPA] (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 . . .” (emphasis added).  The Court was faced with two conflicting provisions, each of which purportedly took precedence over the other through the use of the introductory language “Notwithstanding anything in the [SPA] to the contrary”.

The Sellers argued that the fraud carveout to the exclusive remedies provision was meant to preserve only the Buyers ability to sue for extra-contractual fraud and that claims based on fraudulent representations and warranties had to be brought contractually under the indemnification provisions, and thereby be subject to the Escrow Cap.   The Buyer, on the other hand, argued that the fraud carveout was not so limited and that the specific “notwithstanding” clause in Section 10.10(b), which expressly disclaimed “all limitations on remedies or recoveries,” should prevail over the “notwithstanding” clause in Section 10.4(d) of the SPA.  The Court concluded that the “very broad language” in Section 10.10(b) supporting the Buyer’s interpretation was a reasonable construction of the SPA and, as a result the motion to dismiss had to be denied.

There are two additional considerations that the Court discussed with respect to this first claim. The first consideration involved the requisite pleading standard for fraud claims.  The Sellers argued that a heightened pleading standard based on federal securities fraud cases should be applied.  Instead, the Court reiterated the Delaware standard that “a plaintiff adequately pleads knowledge in the context of fraud when he pleads facts that allow a reasonable inference that the false representation was ‘knowable and the defendants were in a position to know it.’”  Under principles of agency law in Delaware, an employee’s knowledge of fraud is imputed to the company when the employee acts within the scope of his authority.  Applying that standard, the Court found the allegations of employees’ fraudulent accounting practices were sufficient to impute knowledge of the accounting fraud and the fraudulent financial statements to EMSI.

A second consideration involved the non-reliance clauses of the SPA and their drafting to fit within the guidelines of Abry Partners V, L.P. v. F&W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006). Abry prohibits a buyer from making representations that it will not rely on extra-contractual statements or documents and, subsequently, bringing a fraud claim based upon the very statements or documents that were disclaimed in the non-reliance provision.  The Court took notice that the Buyer “has not pursued an extra-contractual fraud claim . . . at least in part, based upon its appreciation that the non-reliance clause would likely complicate the prosecution of that claim.”

With respect to the second claim, the Court had to assess whether the auditor was an arbitrator. In this case, the SPA explicitly noted that the auditor would serve “acting as an expert and not an arbitrator.”  Accordingly, the Court concluded that the auditor’s assessment was not intended to be an arbitration settlement and confirming the assessment as such would render the clear language of the SPA meaningless.  On this basis, the Court granted the motion to dismiss the Buyer’s claim for confirmation under the Delaware Arbitration Act.

EMSI Acquisition, Inc. v. Contrarian Funds, LLC, et al., C.A. No. 12648-VCS (Del. Ch. May 3, 2017)