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| Representations,
Reliance & Remedies: Many of my deals are between Minnesota entities. Minnesota law would be applicable to the transaction,
even if it were not selected as the governing law of the agreement,
which it usually is. Even when
the other side of the transaction is out of state, a Minnesota business
may negotiate for the application of Minnesota law if it has the power,
although often for no better reason that it seems more comfortable
to do so. A significant part of any purchase and sale agreement
for a business is the representations and warranties made by the seller
about the business being sold and its assets.
Indeed in most agreements, whether for the sale of real or
personal property, for the licensing of intangible property — even
for settlement agreements — representations play an important role. There is always significant negotiation over the precise
wording of these representations.
Parties and their counsel believe that representations are
the basis of the bargain and attach a great deal of significance to
them. Buyers of businesses also perform due diligence, a factual
investigation into the state of affairs of a particular business. There are inherent limitations on how much diligence
can be done. The timeframe
for doing diligence is often compressed, communication among the team
doing due diligence is often imperfect, and understanding anything
as complex as a business extremely difficult.
Purchasers do not rely solely on due diligence — the representations
made by sellers are important and always bargained for. In most cases, buyers of businesses expect to have a remedy
if particular representations prove to be untrue.
Sellers negotiate limitations on those remedies precisely because
they too believe that a misrepresentation will result in a claim by
buyer. WHENCE MINNESOTA LAW? I suspect that this result may come as a surprise to many
Minnesota lawyers — but it’s the law (or at least the 8th Circuit
says it’s the law). In Hendricks v.
Callahan1 the 8th Circuit determined that for a buyer to prove
a claim for misrepresentation it needed to show that it “relied” on
the misrepresentation made. In
that case, because the buyer knew that two representations contained
in the purchase agreement were not true, the court found that there
could be no reliance and as a result buyer had no claim. Despite tightly negotiated representations, if a seller
can demonstrate that a buyer “knew” of the falsity of a representation,
it avoids responsibility for the breach. A claim for breach of a representation contained in a
contract requires elements of proof more like a tort claim than a
breach of contract claim. One
element is “reliance” or “justifiable reliance.”
Generally, there is probably a strong societal interest in
such a test. In other situations, the courts have indicated
that buyers have some obligation to operate with their eyes open.
If in fact a buyer knew that a representation is false and
induced seller to make the representation (commonly referred to as
“sandbagging”), should the buyer have a claim against the hapless
seller? But it’s not at all that simple.
First, the purchase of a business is exceedingly complex. Whether a buyer fully appreciates the implications
of some set of facts is always a question. Second, parties in negotiating representations
actually believe that they are bargaining for the representations
being delivered. It is the
combination of due diligence and assurances about a business that
a buyer is relying on. Anyone
who has looked at the debate about whether acquisitions of businesses
enhance shareholder value for the acquiring corporation understands
that buyers already have a heavy burden in capitalizing on a business
purchased. In fact, societal interests probably ought to bend the
other way. Our Legislature
goes out of its way to protect purchasers of homes.
Presumably the seller of a home is in a superior position to
tell the buyer about mold and other problems.
So too the seller of a business.
I’m not suggesting legislative action, but honoring the agreement
of the parties seems the least that the courts could do in the circumstances. HENDRICKS
V. CALLAHAN The Hendricks
court was presented a variety of arguments about why reliance wasn’t
a proper element of proof, including an argument that Minnesota would
adopt the “modern” view reflected in a decision by New York’s highest
court in CBS, Inc. v. Ziff-Davis Publishing Co.2 There the New York Court of Appeals determined
that the parties were really bargaining for the existence of the representation, not its truth. The Hendricks
court was not persuaded. The seller argued that Minnesota law had changed, as demonstrated
by the adoption of the Uniform Commercial Code, which does not require
reliance. The seller also argued
that prior Minnesota law had been overturned sub
silentio through a series of cases.
The 8th Circuit was not persuaded. Instead the court looked back at Midland Loan Finance Co. v. Masden,3 a 1944 case. Midland
involved a claim by a finance company against an auto dealer based
on a usurious conditional sales contract that the finance company
had purchased. There was an
express warranty by the dealer that the contract was enforceable. It was usurious and therefore unenforceable. But because the finance company had actually
been involved in the calculation of the usurious charges, the Minnesota
Supreme Court found that the finance company did not rely on the dealer’s
warranty. The Court stated, without citing any precedent, “To enable
a party relying upon breach of express or implied warranty to recover,
it must be clear and definite that there was actual reliance upon
the warranties involved.”4 It
then quoted from Dunnell’s Digest,5 “In the absence of express agreement
a buyer cannot recover under a general warranty of quality for defects
which were actually known by him at the time of the sale, or for defects
which were obvious to ordinary observation, if he had a convenient
opportunity to inspect the property.” (In Hendricks
v. Callahan there was an express agreement.) One can readily see the difference: in Midland the person attempting to rely on the warranty was solely responsible
for its breach. In fact, the
Court’s conclusion was that “Plaintiff’s actions in this respect constituted
a conscious and willful wrongdoing which would not sustain its present
claim for indemnity for the loss occasioned by and resulting from
its own wrongful acts.”6 In the ordinary purchase and sale, the facts
about the underlying business are in the hands of the seller, and
the buyer, rather engaging in “conscious and willful wrongdoing,”
is merely an innocent purchaser. Based on the rationale of Midland,
the Hendricks court did
not properly apply Minnesota law. A NECESSARY PRECEDENT? The negotiation of a specific remedy dealing with the
same subject matter could have been found to be evidence of what the
parties agreed to. Who negotiates
a specific indemnification and then expects a claim for breach of
representation? Changing the Case Law. One can appreciate the difficulty in
federal courts reading the tea leaves.
But other federal courts have had little difficulty in finding
that states would adopt the modern view.7
If the courts of Minnesota were confronted with the issue,
they could look at the circumstances of the purchase and sale of a
business to determine that Hendricks
is not the correct precedent. But
if the Hendricks decision continues to be recited
as the law of Minnesota, is there anything that buyers should be doing? Choice of Law. Knowing of Hendricks v. Callahan, a seller would want Minnesota law to apply,
while a buyer would surely select the law of another jurisdiction
as the governing law of a contract.
Even when buyer and seller are based in Minnesota, they should
be able to select the law of another jurisdiction to govern their
agreement.8 Litigation in Minnesota would usually be more
convenient, but there is no reason that a Minnesota court could not
apply the law of another state. New York law would appear to be the logical choice. The law of Ziff-Davis is precise, having been decided by the highest New York
court. Preservation of Rights.
The cases involving an attempt to assert a breach of representation
in the purchase of a business are confusing.
Other cases — even New York cases — have found that knowledge
of the breach is enough to defeat a claim.
But it has been pointed out that in those cases there was no
attempt to preserve the claim through a contract mechanism.9 A common provision requested by buyers is an acknowledgment
by seller that any claim for breach of representation will survive
the closing and will survive any investigation made by buyer.
This is an attempt to overcome cases such as Hendricks v. Callahan. Does
it work? Such a provision should
overcome an argument by a seller, attempting to defend a false representation,
that the buyer made an investigation and therefore was charged with
finding the falsity of the representation.
Is it a magic bullet that overcomes the justifiable reliance
defense? The use of such a provision would at least allow courts to
point to it as a factual difference from other cases.
But it is less than satisfying as a legal proposition:
why should inserting a provision readily recognized as boilerplate
produce a different result? Specific Indemnification. Assume that in preparing
disclosure schedules the seller lists a newly filed lawsuit in response
to a particular representation. Buyer
says that it is unwilling to purchase the business and face the exposure.
It asks the seller to delete the lawsuit from the schedule.
Since the lawsuit exists and is not disclosed, buyer believes
that will make seller responsible for the consequences of the litigation. But alas, as we have seen, fixing a schedule
doesn’t avoid the problem since the buyer now knows of its existence. Can the buyer indemnify seller against the litigation? Virtually every business purchase and sale agreement
provides a remedy for breach of representation in the form of indemnification
against such breaches. If that
remedy were not included, a buyer would still have a common law breach
of contract claim. By including
the indemnification clause, does the buyer gain an independent right? There must have been such a clause in the cases
dealing with misrepresentation claims.
But the courts don’t mention them.
That is, there is no indication that indemnification by itself
provides additional relief beyond the general contract claim. Notwithstanding, would a court ignore a clause that says
“we really mean it”? In the
litigation example, if instead of attempting to gain protection by
forcing the seller to remove the new disclosure from an exception
schedule, what if the buyer told the seller it would not go forward
without indemnification (and the agreement was changed to recite that
fact) and an elaborate indemnification clause were included within
the agreement dealing with that specific lawsuit? Could a seller then say, following the closing,
“you knew all about the litigation, we have no further liability”?
Surely, no court would find the provision unenforceable.10
By dealing specifically with the issue, a buyer probably gains
protection. CONCLUSION
2. 75 N.Y.2d 496,
553 N.E.2d 997, 554 N.Y.S.2d 449 (New York 1990). 3. 217 Minn. 267,
14 N.W.2d 475 (1944). 4. 14 N.W.2d at
481. 5. 5 Dunnell
Digest Section 8557. Dunnell’s is now in its fifth edition. 6. 14 N.W.2d at
481. 7. See, e.g., Pegasus Management Co. v. Lyssa, Inc., 995 F.Supp 29 (D. Mass. 1998). 8. Under Section
187 of the Restatement of the Law — Conflict of Laws (2nd) a choice
of governing law by the parties should be respected.
The consequences of the choice of New York law would not produce
results repugnant to Minnesota policy.
The Uniform Commercial Code, as adopted in Minnesota, does
not require reliance. 9. See Quaintance,
“Can You Sandbag? When a Buyer
Knows Seller’s Reps and Warranties Are Untrue,” The M&A Lawyer
(March 2002). 10. As noted above,
in Hendricks v. Callahan
there was specific indemnification against a mechanic’s lien.
When the buyer of the property was unable to resell it because
of the existence of that lien, it claimed that it was entitled to
indemnification for its loss. But
the result in the case probably follows from how the indemnification
provision was drafted, not its impermissible nature. BILL PAYNE is a partner with Dorsey & Whitney in Minneapolis and head of its Mergers & Acquisitions Group. |
