Two recent Delaware Chancery Court cases should remind mergers and acquisitions lawyers to consider the fraud claim risks buyers face—and the cases highlight the need for a more strategic, comprehensive approach to negotiating fraud parameters in light of those risks.
Fraud claims in M&A tend to be high-profile, partly because the underlying facts are often salacious, and the results can be catastrophic. A typical fraud claim in M&A focuses on a lie told by a seller to induce a buyer into a transaction. Rarely do fraud claims run the opposite direction, with sellers claiming they have been defrauded by buyers.
Despite efforts to thoroughly complete due diligence, a buyer must ultimately trust that a seller hasn’t overstated the good, omitted the bad, or obscured the ugly in a transaction. While no seller would argue that it should be permitted to intentionally deceive a buyer, a savvy seller may be concerned that a remorseful buyer will rush to court with a fraud claim for even innocent mistakes.
This is why sellers may push to establish specific parameters for what constitutes fraud, particularly in extracontractual fraud and reckless fraud.
In extracontractual fraud, claims can arise from misrepresentations on the basis of representations made outside the agreement. From a seller’s perspective, it’s hard to determine risk of extracontractual fraud exposure because acquisitions involve many stakeholders, conversations, message exchanges, and disclosures, often over a multi-year period.
From a buyer’s perspective, extracontractual fraud claims are an important legal protection to preserve. Even though extracontractual misrepresentations are related to the deal, the purchase agreement doesn’t often address them. Without a breach of contract claim, a buyer must rely on extracontractual fraud remedies under applicable law.
In common parlance, fraud often connotes intentional deception. But under the law of many jurisdictions, including Delaware, the minimum threshold for fraud is reckless misrepresentation.
This standard introduces further uncertainty for a seller worried that buyer might try to convince a court that every mistake is “an extreme departure from the standards of ordinary care.” Buyers may argue that fraud under law—whatever the details—shouldn’t be shielded and that sellers must remain responsible.
Corporate lawyers invest significant effort in analyzing and negotiating these parameters from the traditional perspectives. But as late last year’s decisions in Fortis Advisors LLC v. Johnson & Johnson and Cytotheryx Inc. v. Castle Creek Biosciences Inc. illustrate, buyers must also consider their exposure to fraud claims.
In Fortis Advisors, Johnson & Johnson acquired Auris Health Inc. for $3.4 billion upfront and $2.35 billion in contingent earnout payments. According to the court, Johnson & Johnson assured Auris during negotiations that a key earnout milestone was “so certain to be met” that it was essentially part of the upfront consideration. However, the court determined that Johnson & Johnson didn’t fully disclose certain risks and pitfalls that lay ahead.
Auris’ former stockholders sued Johnson & Johnson for fraud among other things, citing extracontractual statements such as the assurances about the milestone. Johnson & Johnson argued that the merger agreement barred fraud claims based on extracontractual statements, relying on the integration clause.
However, Delaware law requires express disclaimers of reliance to bar extracontractual fraud claims. While Johnson & Johnson had disclaimed reliance on extracontractual representations by Auris, the court found Auris had made no such disclaimer. Consequently, the court allowed the fraud claims against buyer to proceed.
Cytotheryx involves a different fact pattern with similar hallmarks. In this case, Cytotheryx received deal consideration in the form of Castle Creek’s preferred stock, which Cytotheryx intended to liquidate by redemption in the future. In the course of the deal, Cytotheryx alleged that Castle Creek’s COO assured Cytotheryx that certain obstacles to redemption had been removed.
Cytotheryx sued Castle Creek for extracontractual fraud and Castle Creek filed a motion to dismiss. As in Fortis, the court ruled in Cytotheryx’s favor on a motion to dismiss, citing that integration clauses alone were insufficient to bar extracontractual fraud claims without explicit disclaimers of reliance. The case is currently in the discovery phase, and no trial date has been set.
These cases highlight the need for buyers to reassess their own exposure to fraud claims, particularly when contingent consideration or buyer stock is part of the deal consideration. Several potential oversights warrant attention:
- Buyers often focus on their own limited representations within the agreement and underestimate potential fraud liability arising from extracontractual statements.
- Buyers may be unaware that their own reckless statements can be the basis for fraud, even without knowledge of falsity.
- Buyers may assume that integration clauses or disclaimers of additional representations in agreements provide sufficient protection.
Sophisticated sellers may push for extracontractual and reckless fraud exclusions, ensuring fraud disclaimers protect them unilaterally. To mitigate risk, consider whether buyers should insist that such fraud disclaimers apply reciprocally, protecting both parties.
Sellers would face an uphill battle in rejecting reciprocal protections while advocating for their own limitations. Cases such as Fortis and Cytotheryx may also offer buyers additional negotiating leverage by citing the premise that sellers too should see value in preserving fraud remedies.
Regardless of whether buyers adjust their typical approach to negotiation and drafting, the Fortis and Cytotheryx cases challenge conventional thinking about fraud risks in M&A transactions and may require buyers to consider fraud risk and liability more holistically.
(Updates 13th and 14th paragraphs to clarify details of the case.)
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Russell Hedman is partner in the corporate and finance group at Hogan Lovells, leading and negotiating complex M&A and investment transactions around the world and focusing on sports teams and private equity.
Adrienne Ellman is partner in the corporate and finance group at Hogan Lovells, focusing on M&A and private equity transactions, representing corporate and financial buyers and sellers of public and private companies.
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