Fraud Under Delaware Law - Clear As Mud With A Dash Of Salt-N-Pepa

Let's talk about fraud, baby; let's talk intentionality; let's talk about all the good things and the bad things that may be (in 750 words or less).

If you're reading this column, you're obviously the most talented lawyer you know. You understand every nuance in an M&A deal negotiation. But, have you been paying attention to the word "fraud" lately? Its meaning can vary drastically depending on the jurisdiction that governs your agreements.

I want Delaware law to govern M&A deals. Delaware courts' ruling history and its general business laws are the most comprehensive and flexible. However, this flexibility can sting if you're unfamiliar with it. In Delaware, unlike many other states, "fraud" can mean many different things. In Express Scripts v. Bracket Holdings Corp., the Delaware Supreme Court held that "common law fraud" has several elements. The classic definition includes "scienter," which most people associate with intent to deceive. I bet you've seen "common law fraud" in your documents and felt warm and fuzzy because that must mean real fraud. Comforting, right? Well, the definition of scienter in Delaware also includes "reckless indifference to the truth." Reckless indifference is not clearly defined, but it lies somewhere between stupidity and malice. A party may make a statement (or representation and warranty) that they did not know was false, but that they also did not confirm to be true. In securities purchase agreements, tens or hundreds of shareholders may make representations and warranties regarding the activities and operations of a business without qualification as a matter of risk allocation but may not specifically investigate the veracity of those statements made. Then, in Delaware, they could be exposed to claims for fraud. That's really scary. But, don't worry. Delaware courts to the rescue! Under Arby Partners V, L.P. v. F&W Acquisition LLC, Delaware ruled that certain types of "fraud" can be contractually limited. Then, in Express Scripts, it ruled that intentional or deliberate fraud is different from reckless fraud. Therefore, to protect against claims for reckless fraud, you just need to be specific when using the term "fraud" in your transaction documents: narrow "fraud" to deliberate (or "intentional") fraud, and specifically disclaim reckless fraud for good measure.

If you're a seller, you absolutely must do this. If you're a buyer, you still may want to do it. While buyers will generally want to preserve flexibility and maximize recourse, there are some reasons to think twice.

First, most sellers never imagine that fraud could include the concept of a "very irresponsible mistake." Does your client really want this discussed with the seller? It is a discussion that has the potential to erode trust on the business side (and no lawyer wants to be responsible for that).

Second, and more esoteric, many M&A transactions these days utilize representation and warranty insurance (RWI). In these cases, the definition of "fraud" is critical. This product appears on its face as a panacea: it reduces risk for sellers, lowers cash escrow requirements, and generally aligns interests. So, how does fraud factor into this? Well, first, let's be clear that any claim for fraud by a buyer (or the insurer) is not subject to the limitations in indemnification provisions (unless buyer's counsel is truly out to lunch). Nevertheless, the definition of fraud in the transaction documents will typically govern the definition in the RWI policy. If the term "fraud" is undefined in your documents, it will likely be similarly undefined in the policy, or it will be defined as "common law fraud under Delaware law." If the term "fraud" is limited in the purchase agreement to only provide for deliberate fraud in the making of the representations and warranties therein, the policy will generally follow that more limited definition. If a purchase agreement (and potentially an associated RWI policy) governed by Delaware law does not limit the definition of fraud to exclude recklessness, then a seller, despite expecting to have minimized risk through use of a RWI policy, is actually exposed to potential claims by a buyer under the theory of fraud for acts committed in the pre-closing period for any damages suffered by a buyer without limitation. If claims are paid under the policy in connection with fraud, insurers may decide to exercise their subrogation rights and pursue a seller directly and, even in those cases, buyers may pursue sellers for damages in excess of coverage limits. Just remember, "fraud" means different things in different states, so make sure you know your governing law and pay attention to the details, every time.