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Delaware Chancery Court Declines To Dismiss Acquiror’s Post-Closing Indemnification Claims In Light Of Contractual Ambiguity In Stock Purchase Agreement
05/16/2017On May 3, 2017, Vice Chancellor Joseph R. Slights of the Delaware Court of Chancery declined to dismiss a lawsuit brought by the buyer of EMSI Holding Company (“EMSI”) asserting post-closing claims for indemnification against the sellers—the company’s former investors—for allegedly fraudulent representations made by EMSI in the Stock Purchase Agreement (“SPA”). EMSI Acquisition, Inc. v. Contrarian Funds, LLC, et al., C.A. No. 12648-VCS (Del. Ch. May 3, 2017). Specifically, the Court concluded that extrinsic evidence is required to resolve an ambiguity in the SPA as to whether plaintiff’s indemnification claims were subject to contractual limitations on recovery. Significantly, the Court also declined to import a heightened pleading standard from federal securities fraud cases to assess whether the complaint adequately pleaded that the representations were fraudulent. Separately, the Court dismissed plaintiff’s additional claim for the “confirmation” under the Delaware Arbitration Act of an auditor’s post-closing determination—pursuant to the SPA—of purchase price adjustments, because the SPA “explicitly provide[d]” that the auditor was “acting as an expert and not an arbitrator.”
Plaintiff sued for indemnification under the SPA based on EMSI’s alleged fraud in manipulating its financial statements to induce plaintiff to overpay for the company. Plaintiff claimed that this alleged fraud was a violation of certain representations and warranties provided by EMSI for which the sellers contractually agreed to indemnify plaintiff. Defendants moved to dismiss on the grounds that the SPA expressly capped any post-closing purchase price adjustments and contractual indemnification claims at approximately $9.5 million in the aggregate, which was placed into escrow at closing and was now depleted. Plaintiff argued that the post-closing indemnification “cap” did not apply because of provisions in the SPA that specifically carved out “any action or claim based upon fraud.”
The Court was thus required to decide whether the indemnification cap or the “fraud” exclusion applied where plaintiff’s indemnification claims were based on EMSI’s alleged knowing provision of false representations and warranties in the SPA. The Court ultimately determined that the SPA was ambiguous because the two provisions—each prefaced with the clause “[n]otwithstanding anything in this Agreement to the contrary”—appeared to contradict each other, and both parties could make reasonable arguments for which provision should prevail. It therefore found that extrinsic evidence would be necessary to resolve the issue and declined to dismiss plaintiff’s indemnification claims.
Notably, the Court highlighted that plaintiff had asserted claims only regarding fraudulent misrepresentations included in the SPA. The Court explained that this was because “[t]he SPA contains a non-reliance clause . . . where Plaintiff specifically disclaimed any reliance on extra-contractual representations,” which precludes “extra-contractual fraud” claims under the Court’s decision in Abry Partners V, L.P. v. F&W Acquisition, LLC, 891 A.2d 1032 (Del. Ch. 2006).
In declining to dismiss, the Court also rejected defendants’ contention that fraud was inadequately pleaded in accordance with “guidance from federal securities fraud cases” imposing “a more searching pleading standard” for “inferences involving scienter.” Instead, the Court held, “Delaware law is 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’” (citation omitted). Moreover, Delaware “courts will impute the knowledge of corporate actors to [the] corporate employer ‘when the agent was acting within the scope of his authority,’” and thus “for the Complaint adequately to plead that the Company had knowledge of the fraud, Plaintiff must simply plead that the Company’s employees had knowledge of the fraud.” The Court concluded that the complaint here “readily meets this standard” based on a variety of specific allegations that various company officers had “knowledge of the alleged fraud.”
Separately, plaintiff had also asserted a claim for “confirmation,” under the Delaware Arbitration Act, of the findings of an independent auditor jointly engaged, pursuant to the SPA, to resolve disputes regarding post-closing purchase price adjustments. The Court dismissed this claim, explaining that “[w]hile Plaintiff is correct that in certain instances an ‘expert’s’ decision in a dispute resolution proceeding, or the parties’ course of conduct during a dispute resolution proceeding, may be tantamount to an arbitration, that cannot be the case where the contract language on point expressly states”—as here—“that the auditor/expert is not acting as an arbitrator.”
