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EMSI Acquisition, Inc. v. Contrarian Funds, LLC, et al., C.A. No. 12648-VCS (Del. Ch. May 3, 2017) (Slights, V.C.)

May 3, 2017

In this memorandum opinion, the Court of Chancery denied a motion to dismiss a claim for contractual indemnification based on alleged fraudulent misrepresentations made in a Stock Purchase Agreement (the “SPA”).The Court held that provisions in the SPA  capped the sellers’ liability for breach of representations on behalf of the acquired company in conjunction with a contractual carve-out for any claim “based on fraud” resulted in an ambiguity that was adequate to survive a motion to dismiss under Rule 12(b)(6) and Rule 9(b).  The Court, however, granted a motion to dismiss a claim for confirmation of an arbitration award under the Delaware Arbitration Act, finding that the conclusion of a third-party auditor appointed under the SPA to resolve disputes over net working capital calculations did not constitute an arbitration award where the SPA explicitly provided that the auditor was not serving in the role of an arbitrator. 

Plaintiff EMSI Acquisition, Inc. (the “Buyer”) asserted post-closing claims for indemnification against the selling parties under the SPA (collectively, the “Sellers”) relating to the acquisition of EMSI Holdings Company (the “Company”), on the grounds that the Company breached certain representations by manipulating its financial information prior to the acquisition.  Only two of the eight Sellers were involved in the Company’s management. The parties executed the SPA for a purchase price of $85 million; however, following the closing, the Buyer alleged that it was provided fraudulent financial information based on manipulation of the Company’s accounting policies, including by acceleration of revenue recognition.

The SPA included mechanisms for a post-closing purchase price adjustment, whereby a third-party auditor would resolve disputes regarding net working capital calculations, with any deficiencies to be satisfied exclusively from a designated escrow fund (the “Escrow Funds”).  The SPA also included a set of representations made on behalf of the Sellers as well as more expansive representations made on behalf of the Company, including that the Company’s interim financial disclosed to the Buyer had been prepared in accordance with GAAP and that the Company had not undertaken any changes to its business practices pre-closing with respect to methods of accounting or acceleration of accounts receivable.  The SPA further included disclaimers by both the Sellers and the Company to any representations outside of those expressly set forth in the SPA, as well as a “non-reliance” clause that the Buyer was not relying on any extra-contractual statements on behalf of the Sellers or the Company in entering into the SPA.

The indemnity scheme in the SPA obligated the Sellers to indemnify the Buyer for breaches of any representations of the Sellers or the Company, but limited the Buyer’s exclusive remedy for such breaches to be recovery from any then-remaining Escrow Funds.  The SPA specifically provided that the Buyer’s “sole and exclusive remedy” for any breaches or inaccuracies of representations in the SPA would be its contractual indemnification rights “except . . . in the case of claims for fraud or willful or intentional misrepresentation.”  The SPA, however, also included a provision intended as a carve-out to the limitation on the Buyer’s indemnification rights, which provided that “[n]otwithstanding anything in this Agreement to the contrary . . . nothing in this Agreement or elsewhere shall limit or restrict . . . [Buyer’s] rights or ability to maintain or recover any amounts in connection with any action or claim based upon fraud in connection with the transactions contemplated hereby . . . .” (the “Fraud Carve-Out Provision”).

After the closing a third-party auditor was engaged and determined that the Buyer was due amounts for purchase price adjustments based on improper net working capital calculations in excess of the Escrow Funds.  The Buyer then initiated a complaint seeking indemnification for damages arising from the alleged breach of representations by the Company as well as confirmation of the auditor’s findings under the Delaware Arbitration Act to recover the amount of the purchase price adjustments in excess of the Escrow Funds.

The Court of Chancery rejected the Sellers’ arguments that the Buyer’s claims were subject to the limitation within the SPA that would have capped the recovery at the amount of the Escrow Funds. After reviewing the seminal decision in Abry Partners V., L.P. v. F&W Acquisition LLC and the specific language of the Fraud Carve-Out Provision, the Court concluded that it was at least a reasonable interpretation of the SPA that the parties intended to capture a claim for breach of representation by the Company as a “claim based on fraud” within the carve-out from the limitation on the Sellers’ indemnification liability.  The Court’s conclusion was based on the broad language employed in the Fraud Carve-Out Provision, including its specific inclusion of a “notwithstanding” clause which specifically identified the other provisions in the SPA relating to the cap on the Sellers’ indemnification obligations.  Moreover, the Court rejected the Sellers’ position that, consistent with the Abry Partners decision, the Fraud Carve-Out Provision could be interpreted only to apply to extra-contractual claims “based on fraud” for the Sellers’ own fraudulent actions (i.e., the Sellers had knowledge that the Company’s representation were false).  The  Court concluded that in light of the competing interpretations of the SPA, extrinsic evidence would be required to construe the indemnification provisions and therefore dismissal under Rule 12(b)(6) was not appropriate. 

The Court of Chancery then applied the pleading standard of Rule 9(b) and cited a litany of allegations catalogued by the Buyer which supported the alleged manipulation of the Company’s accounting policies by its employees prior to the closing.  The Court held that sufficient facts were plead to create a reasonable inference that the alleged fraud was knowable by the Company and therefore denial of the motion to dismiss was warranted.

Finally, the Court of Chancery addressed whether the findings of a third-party auditor with respect to the resolution of disputes regarding the calculation of net working capital pursuant to the SPA constituted an award that may be “confirmed” under the Delaware Arbitration Act.  The Court held that because the SPA explicitly provided that the auditor would be “acting as an expert and not an arbitrator” and that under Delaware law parties will not be deemed subject to arbitration without a clear manifestation of that intent, the plain meaning of the SPA dictated that the auditor’s determination clearly was not an arbitration award that could be confirmed under the Delaware Arbitration Act.

The full opinion is available here