By Eric Feldman and James Parks
On a motion to dismiss in Prairie Capital III, L.P. v. Double E Holding Corp., the Delaware Court of Chancery, granting in part and denying in part the defendant’s motion, re-enforced the importance of bargained-for contractual terms in the context of a dispute over a transaction consummated pursuant to a stock purchase agreement.
The case involves a transaction between two private equity firms, Prairie Capital Partners and Incline Equity Partners. Prairie Capital Partners, through its sponsored funds Prairie Capital III, L.P and Prairie Capital III QP, L.P. (collectively, “Prairie Capital”), owned Double E Parent LLC (the “Company”), a portfolio company, which it sold to Double E Holding Corp., which was an acquisition vehicle formed by Incline Equity Partners III, L.P., which was sponsored by Incline Equity Partners (collectively the “Buyer”). Prairie Capital III L.P. and Prairie Capital III QP, L.P. (the “Sellers”) were the principal sellers, and the Stock Purchase Agreement (the “SPA”) was signed and the transaction closed on April 4, 2012. The SPA established an escrow fund for a limited period of time for the parties’ respective indemnification obligations and included procedures to make a claim against such escrow fund.
During negotiations, Prairie Capital and the Company spun a story of steady growth, presenting the Company as a cash-generating business that had an excellent history of collecting accounts receivable and maintaining strong working capital. Incline was interested in acquiring the Company as a result, but conditioned its offer on the Company maintaining its robust monthly sales —specifically stating that if the Company did not hit its March 2012 sales figure (the last month before the transaction closed), it reserved the right to walk away from or renegotiate the deal. By mid-March it had become clear to Prairie Capital and the Company that it would not hit the $3.2 million in projected sales. To keep the sale on track, Fortin and Vancura, two officers of the Company (together, the “Prairie Capital Officers”), and McNally and Killackey, two directors of the Company (together, the “Prairie Capital Directors”), contrived to speed up the production of certain orders (outside of the ordinary course of business) and fraudulently altered the Company’s financial records to make it appear that the Company had hit its target. Based upon the fraudulent records, Incline agreed to close.
Immediately prior to the expiration of the escrow fund, when the amounts therein would have otherwise been released to the Sellers, the Buyer made a claim. The claim notice asserted, among other things, that the March 2012 financial statements were fraudulent, although it did not include in the notice any allegations of fraudulent conduct before March 2012. Subsequently, Prairie Capital brought suit against the Buyer to compel the release of the escrow and the Buyer counterclaimed for fraud, aiding and abetting fraud and conspiracy to engage in fraud against the Prairie Capital Officers, Prairie Capital, and the Company as well as various indemnification claims for breaches of the SPA. The plaintiffs moved to dismiss the counterclaim.
A claim for fraud requires the plaintiff to establish (i) a false representation, (ii) the defendant’s knowledge of or belief in its falsity or the defendant’s reckless indifference to the truth, (iii) the defendant’s intention to induce action based on the representation; (iv) reasonable reliance by the plaintiff on the representation; and (v) causally related damages. In its counterclaim, the Buyer identified two classes of false representations: (1) extra-contractual oral and written communications outside of the SPA, and (2) contractual representations that appear in the SPA.
As to the first, the Court held that the SPA foreclosed extra-contractual false misrepresentation claims of fraud because of an Exclusive Representations Clause and an Integration Clause that were sufficiently specific to constitute an enforceable contractual promise on the part of the Buyer that it “did not rely upon statements outside of the contract’s four corners in deciding to sign the contract.”
The Court also held that the same clauses forbade extra-contractual material omission claims. The Court reasoned that because Delaware law permits parties to “identify a universe of contractually operative representations in a written agreement,” they must “remain in that universe,” and cannot “escape through a wormhole into an alternative universe of extra-contractual omissions.” The critical distinction was not between false misrepresentations and omissions, but between “information identified in the written agreement and information outside of it.” Recognizing that artful pleading could twist any misrepresentation into an omission and distinguishing Transdigm Inc. v. Alcoa Fasteners, Inc., 2013 WL 2326881 (Del. Ch. May 29, 2013), the Court held that an Exclusive Representations Clause has a representation defining effect that extends to claims based on both misrepresentations and omissions.
As to the contractual fraud claims, the Court refused to dismiss the majority of the Buyer’s counterclaims, only striking down an overly broad counterclaim where the Company had solely made representations regarding a certain time period and disapproving of a “bootstrapped claim” that the Company had breached a “Compliance with Laws” representation via the very same fraud alleged in the suit.
Because of their participation in the scheme at hand, the Court held that the Company, the Prairie Capital Officers, the Prairie Capital Directors and the Sellers could all be held liable for the fraud.
As to the secondary liability claims, the Court held that the Buyer stated a claim as to Prairie Capital Partners either aiding and abetting the fraud or engaging in a conspiracy to commit fraud, based upon the participation of such fund (through the Prairie Capital Directors) in the artifice.
As to the indemnification claims, based primarily on the language of and procedure provided for in the SPA, the Court upheld the Buyer’s use of a general notice of claim specifying misconduct in March 2012 and declined to dismiss such claims. The Court, however, granted the motion to dismiss as to indemnification claims occurring before the specified period on the theory that the notice of claim did not include allegations of misconduct prior to March 2012 and the claim notice provided could not stand in for all possible causes of action pre-March 2012.