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The Dreaded Fraud Exception

The Anatomy of a Deal Newsletter

Smart Summary 

  • The dreaded “fraud exception” is a massive hole that typical “exclusive remedies” can’t close in an M+A deal.
  • By asserting fraud, some nefarious buyers can find ways to bring a claim against a seller without having to maneuver through the indemnification limitations.
  • Savvy sellers must be sure to include a clear “exclusive remedies” provision that excludes fraud, but not things like “intentional misrepresentation” and “willful misconduct.”
  • Because the fraud exception should rightly be invoked only in very serious cases, most buyers will agree to some contractual fraud standard that provides clearer expectations to both parties as to what should constitute “fraud” in the deal.

We’ve talked in past installments about indemnification claims and the various limitations that exist to protect sellers, such as baskets, caps, and survival periods. Without getting too technical, these limitations only work, as a legal matter, because they are implemented via an “exclusive remedies” provision in the definitive agreement, which states that the buyer generally can’t assert any type of claim against the seller except under the contractual indemnification provisions set forth in the definitive agreement (which is where we include each of these agreed-upon limitations).

But after carefully negotiating each of the representations, warranties, indemnities, and limitations, there remains one potential big hole that our “exclusive remedies” provision can’t close: the fraud exception. That’s because none of the contractual limitations apply to fraud at all. So a claim fashioned as a fraud claim might afford the buyer a way to side-step all of the contractual limits and claw back a much bigger piece of the purchase price from the seller.

We often think of fraud as being a big deal, and it is. However, there’s more gray area to fraud than you might expect, which could lead to more uncertainty down the road when a creative buyer starts trying to think of ways to assert a claim against the seller without having to maneuver through the various indemnification limitations. That’s because fraud in this context is generally a “common law” claim, meaning that it’s developed by judges in court cases over time, rather than as the product of a legislatively adopted statute.

The classic common law definition of fraud requires that the buyer prove each of the following elements:

  1. a misrepresentation of fact;
  2. made with knowledge that the statement is false;
  3. with an intention that the other party rely on that misrepresentation;
  4. the other party justifiably relies on the misrepresentation; and
  5. the other party is actually hurt as a result.

If any of those five elements is missing, there’s no fraud.

And while we often say that “anyone can sue anyone for anything in the U.S.,” it’s often at least a little harder to do so for fraud. That’s because the law generally requires that a fraud claim be described with “particularity” in the complaint that initiates a fraud claim. So if the buyer can’t put together a relatively strong case for fraud at the initial stages of the lawsuit, the buyer’s fraud claim may never get off the ground.

If you’ve read this series before, you knew it couldn’t be that easy, right? And it’s not. Over the years, different courts in different states have created various modifications and permutations to the classic fraud definition. While beyond the scope of this article, there are all kinds of different permutations of fraud, such as actual fraud, fraud in the inducement, and others.

And if all of that’s not confusing enough for you, clever buyers also try to expand the fraud exception to include things like “intentional misrepresentation” or “willful misconduct.” Those seem pretty innocuous, right? But unlike fraud, which has at least some legal meaning and is often subject to the higher “particularity” standard for initiating a lawsuit in the first instance, these terms don’t really have independent legal meanings and don’t require the buyer to jump through additional hoops. So a buyer could avail itself of the fraud exception—thereby exposing the seller to much greater liability—without proving all of the elements of fraud.

So, what are sellers to do? A few key steps below:

  1. If you do nothing else, make sure that there’s a clear “exclusive remedies” provision that excludes “fraud,” but not things like “intentional misrepresentation” and “willful misconduct.” Even with its ambiguities, the case law defining “fraud” provides much more protection than these wishy-washy concepts. And don’t fall in the trap if a buyer is suggesting that this isn’t a big deal.
  2. Include clear “non-reliance” language in the definitive agreement, whereby the buyer confirms that it hasn’t relied on any information outside of the express language contained in the definitive agreement. This helps to avoid would-be fraud claims based on non-contractual statements the sellers may have made along the way, or in the information shared with the buyer during the due diligence process, but which don’t become part of the final contract.
  3. Know which state’s laws apply to your deal, and what that state’s law says about fraud. Some states provide for a more certain application of fraud laws than others.
  4. To the extent possible, take as much of the decision out of a judge’s hands by defining “fraud” in the definitive agreement. An example of a fairly seller-friendly “fraud” definition follows:

“Fraud” means, with respect to a party, an actual and intentional misrepresentation of a material existing fact with respect to the making of any representation or warranty in Article 3 or Article 4 hereof, as applicable (in each case, as modified or supplemented by the Disclosure Schedules), which constitutes actual common law fraud in the state of Delaware. A party will be liable for, or as a result of, such party’s Fraud only if such party had actual knowledge of such party’s Fraud and the party or Person alleging any loss or other damage or claim due to the Fraud reasonably acted in reliance on such false representation or warranty and suffered or incurred losses as a result of such reliance.

As you saw, I called out some key phrases in this definition. Some of the reasons those phrases are important:

  • “…actual and intentional misrepresentation…” – This confirms that we’re talking about “actual and intentional” fraud only, not one of the other flavors of fraud that a judge might summon in this case.
  • “…material existing fact…” – Here, we cover two important points: (1) the fact must be material (not something that isn’t all that important when viewed in the context of the broader transaction), and (2) it must be “existing” at the time of the misrepresentation. This helps to avoid the sometimes blurry line between things that actually “are” at a given moment, and those that “may become” something later. In other words, fraud should not be forward-looking.
  • “...making of any representation or warranty in Article 3 or Article 4 hereof…” – The article references don’t mean much without the benefit of understanding the rest of the agreement, but those references are actually critically important. This phrase makes clear that the only “statements” that can lead to fraud are those set forth in the specifically identified sections of the definitive agreement. Statements made outside of the agreement aren’t the basis for a fraud claim, because the buyer has been instructed not to rely on those statements—just those in the agreement itself. These off-the-cuff statements made by sellers are the ones that are much more dangerous, and so we want them to be excluded.
  • “…which constitutes actual common law fraud…” – This reinforces the conclusion that a “Fraud” claim here requires an actionable claim for “actual fraud” under the applicable state law, and in this case, must meet the classic fraud elements—nothing more.
  • “…state of Delaware…” – The state matters, and here we’re clear that the state is Delaware, which has a fully developed body of law around fraud, particularly in complex transitions.
  • “…actual knowledge…” – As stated above, a typical fraud claim generally requires proof that the seller knew the statement it was making was false. This is a big part of what separates fraud from the laundry list of other possible claims a buyer could make. So it’s important that we’re clear on this point. Moreover, by specifying “actual knowledge,” we limit the risk that a court might imply some imputed knowledge standard on the seller (i.e., the seller didn’t actually know, but he/she should have known).
  • “…reasonably acted in reliance on such false representation or warranty…” – Again, we tie back to the classic fraud elements here, with the important point being that the buyer must prove not only that the seller—with knowledge—made a misrepresentation in the definitive agreement, but that the buyer appropriately relied on that misstatement. In the context of the buyer’s due diligence and other pre-closing investigations of the target company, it often may not be reasonable to assume that the buyer would rely only on the seller’s statements with respect to material issues.
  • “…suffered or incurred losses as a result of such reliance…” – And finally, hearkening back to the classic fraud definition, the buyer must prove that the buyer was actually harmed by relying on the seller’s misrepresentation.

If any of the above elements is missing, then there’s no fraud. Case closed (at least it should be).

Of course, most buyers won’t blindly accept a seller-favorable fraud definition. And for good reason: if the seller truly is trying to defraud the buyer, the buyer needs to make sure it can be made whole. However, because the fraud exception should rightly be invoked only in very serious cases, most buyers will agree to some contractual fraud standard that provides clearer expectations to both parties as to what should constitute “fraud” in the deal.

Sometimes buyers will try to convince sellers to drop the fraud discussion by saying something like this: “What’s the big deal. You’re not trying to defraud me, are you?” But smart sellers don’t fall for this. The fraud discussion isn’t about trying to protect the seller from genuine fraud; it’s about making clear that “fraud” means only what it’s supposed to mean and that the buyer doesn’t have the ability to sidestep the indemnification limitations by expanding the fraud definition in unintended ways.

Next Month: Tying it All Together—Exit Planning for Private Companies

Read last month’s piece: Loose Lips: How to Maintain Confidentiality When Pursuing a Deal

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