There are always risks involved in buying a company. Until you are actually inside a company's operations, you can never be sure you know everything about it. Conversely, sellers too will bear the risk that buyer's remorse will lead to post-closing claims against the sellers when they no longer have the company assets to use to defend themselves. Two related, recent Delaware Court of Chancery decisions illustrate the hidden risks when buyers and sellers try to allocate between them the inherent risks in a deal.
EMSI Acquisition v. Contrarian Funds, (May 3) (EMSI I), held that despite extensive attempts to limit a buyer's right to sue sellers, the contract of sale did not foreclose claims of fraud. The buyers did not get all they wanted, however. In Davis v. EMSI Holding, (May 3) (EMSI II), the same court also held the buyers had to advance the sellers' costs to defend themselves. In short, the terms of the stock purchase agreement (SPA) the buyers and sellers negotiated failed to fully satisfy either side. This is worth examining.
Both these decisions involved the sale of EMSI Holding Co. by its institutional investors and two of its managers. After the sale, the buyer discovered that EMSI had falsely stated its revenues, resulting in an inflated sales price. It sued the institutional sellers and two managers. The institutional sellers defended on the basis that the SPA limited the buyer's right to recover, except for a deliberate fraud committed by false terms in the SPA itself. In other words, unless the representations and warranties in the SPA were known by the institutional sellers to be false, the sellers argued they had no liability even if those statements in the SPA turned out to be wrong. Given that those sellers were not actually managing EMSI with inside information about its real revenues, such a defense could prove to be effective under the well-known Delaware decision in Abry Partners V v. F&W Acquisition, 891 A.2d 1032 (Del. Ch. 2006).
Abry stated two important principles for any agreement among sophisticated parties that is governed by Delaware law. First, an appropriately drafted no-reliance clause will foreclose a buyer from contending that it was misled by any statements outside of the parties' written agreement. Second, even misstatements within the agreement itself may be foreclosed as a basis for suit unless made with an "illicit state of mind." EMSI I held that the SPA was ambiguous with respect to what claims were precluded and thus Abry may not bar the buyer's claim. The obvious lesson then is to draft clearer agreements.
The buyer did not get off entirely, however. For in EMSI II, the court also held that the SPA did not waive the right of the two selling managers to have their litigation expenses advanced by the buyers of EMSI. Their right to advancement stemmed from the EMSI bylaws. The SPA did not cancel those bylaw rights. Note that, once again, the SPA might have done so with different language.
There are at least three specific lessons from EMSI I and II. First, a buyer's rights to seek post-closing remedies should be addressed in one section of any agreement. One of the problems encountered in EMSI I stemmed from the multiple cross-references in the SPA to that topic. While the court did note that the SPA had "a comprehensive indemnification regime," even so the SPA was ambiguous. It had "two apparently conflicting" indemnification clauses that the court found "appear to 'override' [one another]."
Second, it is important to focus on who is going to indemnify the buyers if a valid claim exists. When the sellers of a business are not part of its actual management, they will be more reluctant to indemnify for misstatements they are unaware are incorrect. Discovering the facts is what due diligence is for and buyers should act diligently in those circumstances. Of course, to state the obvious, indemnification from the company being bought is worthless to a buyer.
Third, virtually every Delaware company will have bylaws provided for indemnification and advancement to its managers, be they directors or officers. If those rights are not to apply in suits arising out of the purchase of the company, it is best to say so explicitly. That does not mean all the managers need lose those rights, just the selling managers, and then only in the use of litigation filed by the buyers.