Learn about the fraud exception in M&A indemnification through a case illustration. Understand how a buyer successfully claimed damages beyond the indemnification cap for seller fraud in an acquisition deal.
M&A Stories
July 28, 2021
Introduction:
In M&A deals, it’s standard practice to include a cap on the seller’s liability to indemnify the buyer for any breach of the acquisition agreement’s representations and warranties. However, this indemnification cap may not apply in cases of seller fraud.
The Deal:
In 2015, a business process outsourcing company acquired the stock of a multinational software corporation in a $112 million strategic transaction. The buyer conducted financial due diligence through a reputable accounting firm, and the sellers represented that the target’s financial statements were accurate, its projections were reasonable, it had no undisclosed liabilities, and its business complied with the law.
The Lawsuit:
After the deal closed, the buyer sued the sellers in a Manhattan court, alleging breach of contract and fraud. The buyer claimed that the sellers engaged in fraudulent activities to hide a tax underpayment issue in China. The fraud involved falsifying documents, bribing auditors, and inflating the target company’s earnings. The buyer argued that due to the deception, they overpaid for the target, leading to significant financial losses.
The Court’s Ruling:
The sellers attempted to have the fraud claim dismissed, but an intermediate appellate court reversed this decision. The court found the buyer’s allegations of justifiable reliance on the target’s documents during due diligence to be sufficient to support a fraud claim. Additionally, the court noted that the sellers’ knowledge of the fraud could be inferred due to its alleged pervasive nature. The court also considered the hidden nature of the fraud and the practical impossibility of discovering it through ordinary diligence, meeting the duty to disclose requirements for fraudulent concealment. The court ruled in favor of the buyer, allowing them to recover damages beyond the indemnification cap.
This case is referred to as VXI Lux Holdco, S.A.R.L. v SIC Holdings, LLC, Index No. 652064/17, Appeal No. 13913, Case No. 2020-02978, Appellate Division of the Supreme Court of New York, First Department, (Decided May 25, 2021). https://scholar.google.com/scholar_case?case=1752976037039427209&q=%22stock+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2020
Conclusion:
In M&A transactions, sellers’ indemnification obligations for breach of representations and warranties are usually capped. However, a crucial exception for fraud enables buyers to seek compensation beyond the indemnification cap if they can prove that the seller engaged in deceptive practices that were essentially undetectable during due diligence.
By John McCauley: I help people manage M&A legal risks.
Email: jmccauley@mk-law.com
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Check out my book: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles
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