In an unpublished opinion, TransDigm Inc. v. Alcoa Global Fasteners, Inc., 2013 WL 2326881 (Del. Ch. May 29, 2013), the Delaware Court of Chancery has held that even if a buyer disclaims reliance on any representations and warranties outside of a stock purchase agreement, the buyer may nevertheless pursue claims that the seller fraudulently concealed material information. Id. at *1. The court, however, indicated that the existence of language in purchase agreements “expressly disclaiming reliance on both the omission of information and extra-contractual representations” may preclude such fraudulent concealment claims by buyers. Id. at *9. TransDigm illustrates the dangers sellers face in failing to disclose certain information to buyers during diligence periods and in making representations during such periods that are not contained within their purchase agreements. Sellers should therefore review the existing disclaimers that they have made in any purchase agreements to which they are parties that are governed by Delaware law so as to determine their potential exposure to fraudulent concealment claims. Sellers should also consider incorporating language in their purchase agreements expressly disclaiming reliance on both omissions of information and extra-contractual representations for current and future deals. Conversely, buyers should (1) carefully examine the language of disclaimers in their purchase agreements governed by Delaware law to determine to what extent they will have a remedy for extra-contractual omissions or commissions made by sellers during diligence periods, (2) reject any disclaimers that limit sellers’ liability for extra-contractual omissions or commissions (or reduce their purchase prices to account for the increased uncertainty of the true financial value of the assets or securities that they seek to purchase), and (3) negotiate an appropriate allocation of risk by opposing any unreasonable temporal limitations on sellers’ representations and warranties.
The TransDigm casearose from a dispute between the sellers, TransDigm, Inc., a Delaware corporation (“TransDigm”), which is the parent company of McKechnie Aerospace Investments, Inc. (“McKechnie USA”), a Delaware corporation, and McKechnie Aerospace (Europe) Ltd. (“McKechnie UK”), a company organized under the laws of England and Wales (collectively, the “Sellers” or “TransDigm”), and Alcoa Global Fasteners, Inc., a Delaware corporation (the “Buyer” or “Alcoa”). Buyer purchased from Seller all issued and outstanding shares of Linread Ltd. (“Linread”) and Valley–Todeco, Inc. (“Valley,” and together with Linread, the “Fastener Subsidiaries”). Id. at *1-2. McKechnie USA was the sole shareholder of Valley, and McKechnie UK was the sole shareholder of Linread. Id. at *2.
Buyer and Sellers entered into a stock purchase agreement executed on January 28, 2011 (the “SPA”), pursuant to which Buyer purchased the Fastener Subsidiaries, which designed, developed, manufactured and distributed fasteners, fastening systems, and bearings. Id. One of Linread’s major customers was the aircraft manufacturer Airbus. Airbus had contracted with Linread to purchase lockbolts from Linread under a contract (the “Airbus Contract”), the term of which ran from January 1, 2005 until December 31, 2008. In 2008, Airbus and Linread agreed to extend the term of the Airbus Contract for four years. Id.
While investigating Linread’s business as part of its diligence process, Buyer learned that Linread’s business relationship with Airbus was essential to its financial success. Id. Consequently, Buyer asked a number of questions of Sellers’ representatives about the status of the Linread-Airbus relationship before Buyer executed the SPA. These questions included inquiries relating to the scope of Linread’s business with Airbus, the strength of Linread’s relationship with Airbus, and the potential that the relationship would succeed. Id. Buyer specifically asked Sellers’ representatives whether any disputes existed between Linread and any of its customers, including Airbus, regarding any matter, including pricing, andSellers’ representatives replied that no such disputes existed. Id. Moreover, Buyer specifically asked Sellers’ representatives about the payment terms that controlled Sellers’ agreements with its customers, including Airbus, and whether such agreements included “cost savings, rebate requirements, or price negotiations.” Id. The issues in the TransDigm case arose because Sellers intentionally did not reveal some of this information in its responses to Buyer’s inquiries. See id.
After executing the SPA and closing the deal on March 8, 2011, Buyer learned of two significant exchanges that took place between Sellers and Airbus prior to the closing. Id. First, on October 26, 2009, Airbus officials communicated to McKechnie UK and Linread representatives that Airbus was dissatisfied with the prices that Airbus was paying for certain lockbolts under the Airbus Contract, and McKechnie UK’s Chief Executive Officer made a verbal agreement, which was subsequently memorialized in an email by Linread’s General Manager that was sent on December 18, 2009, to provide Airbus with a five-percent discount to Airbus on all lockbolts purchased under the Airbus Contract starting on January 1, 2012. Id. Airbus accepted this discount in September, 2010, several months before the SPA between the Sellers and Buyer was executed. Second, Airbus had indicated to McKechnie and Linread in a meeting among them that took place on October 6, 2010 that Airbus “seriously was considering moving 50%-55% of its lockbolt business to a European competitor.” Id. Buyer also alleged that McKechnie UK’s President emailed the General Manager of Linread on January 1, 2011, twenty-seven days before the execution of the SPA and the closing, communicating to the General Manager that McKechnie UK’s President was “not sure what Alcoa knows about our Airbus business and their direction on lockbolts with them” and that he “would keep the story consistent and speak to the expiration date only.” Id. at *3.
When Sellers filed a two-count complaint against Buyer on unrelated matters, Buyer counterclaimed. The Court of Chancery’s opinion concerns the motion to dismiss these counterclaims. The first counterclaim, captioned “Count II,” was for fraudulent and active concealment of material information. Id. The second and third counterclaims, captioned “Count III” and “Count IV,” respectively, asserted claims for fraudulent or negligent misrepresentation based on two sections of the Purchase Agreement. One of these sections, Section 4.19, stated, “Since December 31, 2010, none of the customers listed on Section 4.19(a) of the Disclosure Letter has … (iii) changed or indicated an intention in writing to Parent, TransDigm, Company, U.S. Seller and UK Seller to materially change the economic terms on which it is prepared to purchase from a Fastener Subsidiary.” Id. The second section at issue, Section 4.8, stated, in part, “Since December 6, 2010, there has not occurred, nor has there been any change or event which has had, or would reasonably be expected to have, a Material Adverse Effect.” Id. The fifth counterclaim, captioned “Count V,” was for civil conspiracy based on the fraudulent acts that Buyer alleged supported Counts II, III, and IV, respectively. Id.
Choice of Law
he first part of the court’s analysis concerned the applicable choice of law. Sellers and Buyer had agreed in the Purchase Agreement that their contract would “be governed by the laws of the State of Delaware, its rules of conflict of laws notwithstanding.” Id. at *4. Buyer, citing Gloucester Holding Corp. v. U.S. Tape, 832 A.2d 116 (Del. Ch. 2003), however, sought to have the law of another state applied. Gloucester Holding applied the “most significant relationship test” set forth in Section 145(1) of the Restatement (Second) of Conflicts of Law (the “Restatement”) to determine that Massachusetts law applied to tort claims related to the formation of an asset purchase agreement that had a choice of law provision specifying that the asset purchase agreement would be governed by Delaware law. Id. at 123-124. In the TransDigm case, Buyer maintained that the choice of law provision in the Purchase Agreement applied only to contract claims, not claims for fraud, fraudulent misrepresentation, and civil conspiracy. Sellers, on the other hand, argued that the parties intended, ex ante, for Delaware law to apply to claims related to the Purchase Agreement. Moreover, Sellers asserted that the Court of Chancery’s decision in Abry Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032, 1034 (Del. Ch. 2006), should control because the issues presented in Abry were closer to those presented in the instant case than those decided in Gloucester Holding. In Abry Partners, Vice Chancellor Strine had acknowledged that the Court of Chancery had relied on Section 145 of the Restatement in Gloucester Holding, but he nevertheless determined that Section 201 of the Restatement ought to have applied in that case. See id. at 1047 n.24.
Section 201 of the Restatement states: “[t]he effect of misrepresentation, duress, undue influence and mistake upon a contract is determined by the law selected by application of the rules of §§ 187-188.” Restatement (Second) of Conflict of Laws (1971). Section § 187(1) of the Restatement states that the law of the state chosen by the parties to govern their contractual rights and duties applies so long as the particular issue is one that the parties could have resolved by an explicit provision in their agreement directed to that issue. Section § 187(2) of the Restatement states the general rule that the law of the state chosen by the parties to govern their contractual rights and duties applies, notwithstanding the fact that the particular issue is one that the parties could not have resolved by an explicit provision in their agreement directed to that issue. Two exceptions, however, are set forth in the Restatement. First, if the chosen state “has no substantial relationship to the parties or the transaction and there is no other reasonable basis for the parties’ choice,” then the law of the state chosen by the parties does not apply. Id. § 187(2)(a). Second, if the “application of the law of the chosen state would be contrary to a fundamental policy of a state which has a materially greater interest than the chosen state in the determination of the particular issue and which, under the rule of [Section] 188,” which applies in the absence of an effective choice of law provision by the parties, “would be the state of the applicable law in the absence of an effective choice of law by the parties,” then the law of the state chosen by the parties does not apply. Id. § 187(2)(b).
The court in TransDigm agreed with Vice Chancellor Strine’s reasoning in Abry that Section 201 of the Restatement “provides the appropriate framework for determining the law applicable to claims for fraud in the inducement and fraudulent misrepresentation.” TransDigm Inc., 2013 WL 2326881 at *5. Therefore, the court determined for the threshold issue of which state’s law the court should use for resolving the issues Buyer raised in Counts II-V of its counterclaim that the appropriate choice was Delaware’s.
Fraudulent and Active Concealment of Material Information
In TransDigm, the court first addressed the heightened pleading requirements for fraud. In Delaware, a plaintiff must make six allegations in order to state a claim for fraud: “(1) the defendant falsely represented or omitted facts that the defendant had a duty to disclose; (2) the defendant knew or believed that the representation was false or made the representation with a reckless indifference to truth; (3) the defendant intended to induce the plaintiff to act or refrain from acting; (4) the plaintiff acted in justifiable reliance on the representation; and (5) the plaintiff was injured by its reliance.” Id. at *6 (quoting Crescent/Mach I P’rs, L.P. v. Turner, 2000 WL 1481002, at *18 (Del. Ch. Sept. 29, 2000), quoted in Abry, 891 A.2d at 1050).
As the court in TransDigm noted, common law fraud can occur in three different ways. First, a party can make an overt misrepresentation. Second, a party may have a duty to speak and be silent. Third, a party may deliberately conceal material facts. Id. at *6. The gravamen of Count II of the Buyer’s counterclaim was that Seller deliberately concealed material facts. To show active concealment, the court observed, the plaintiff “must show that a defendant took some action affirmative in nature designed or intended to prevent, and which does prevent, the discovery of facts giving rise to the fraud claim, some artifice to prevent knowledge of the facts or some representation intended to exclude suspicion and prevent inquiry.” Id. (quoting Metro Commc’ns Corp. BVI v. Advanced Mobilecomm Techs. Inc., 854 A.2d 121, 150 (Del. Ch.2004)). Proving a claim of fraud based on active concealment, however, does not require first establishing that the defendant had a preexisting duty to speak. TransDigm Inc., 2013 WL 2326881 at *6. The court noted additional pleading requirements for fraud in Delaware. These include the requirements under the Court of Chancery Rule 9(b) that the “circumstances constituting fraud” be stated “with particularity,” although, as the court recognized, the rule provides that intent and knowledge may be generally averred. Ct. Ch. R. 9(b). These pleading requirements also include the requirement that the fraud allegation include the “time, place and contents of the fraudulent act or omission and what was obtained thereby,” TransDigm Inc., 2013 WL 2326881 at *6, as well as “the identity of the persons engaged in the conduct giving rise to the claim of fraud.” Id. at *7.
The court in TransDigm held that Buyer adequately alleged fraudulent and active concealment of material information because (1) Buyer’s allegations in its counterclaim stated a prima facie claim for fraudulent and active concealment and (2) the language in the Purchase Agreement did not preclude Buyer’s claim of fraudulent and active concealment. With respect to the issue of whether Buyer made a prima facie claim, the court noted several significant facts. First, Buyer alleged that in late 2009, a McKechnie UK executive officer and Limead’s General Manager offered, and Airbus later accepted, the five-percent discount that was to be applied on January 1, 2012 and thereafter. Id. at *6. Second, Buyer averred that a TransDigm representative instructed Limead’s General Manager “not to discuss the potential loss of 50%–55% of Airbus’s lockbolt business with anyone and not to discuss anything, including Airbus matters, with anyone at Alcoa.” Id. Third, Buyer alleged that during a January 6, 2011 meeting, shortly before the Purchase Agreement was executed, Buyer had asked Sellers’ representatives about payment terms relating to Airbus, but Sellers did not reveal during that meeting or at any time prior to the execution of the Purchase Agreement that “Airbus was seriously considering moving at least one-half of its lockbolt business from Linread to another competitor or that Linread had promised (and Airbus had accepted) the five-percent discount . . . .” Id. Based on these facts, the court found that it was “reasonably conceivable” that Alcoa could prove that the TransDigm representatives who attended the January 6, 2011 meeting were told of the information known by (a) a McKechnie UK representative, who allegedly sent the email stating that he was “not sure what Alcoa knows about our Airbus business and their direction on lockbolts with them” and that he “would keep the story consistent and speak to the expiration date only,” to Limead’s General Manager on January 1, 2011, and (b) Limead’s General Manager. Id. at *7. Therefore, it was reasonably conceivable that such TransDigm representatives “intentionally omitted or concealed information” from Buyer. Id. Alternatively, the court concluded, even if the TransDigm representatives did not know what McKechnie UK’s representative and Limead’s General Manager knew (and therefore did not inform Buyer of the information about Airbus’s discontent or the discount it was given), a colorable claim existed that such ignorance was a result of the active concealment by Limead’s General Manager and others. Id.
To determine whether the Purchase Agreement barred Buyer’s fraud claim, the court initially analyzed the language of one provision of the Purchase Agreement, which stated:
Buyer has undertaken such investigation and has been provided with and has evaluated such documents and information as it has deemed necessary to enable it to make an informed decision with respect to the execution, delivery and performance of this Agreement and the transactions contemplated hereby. Buyer agrees to accept the Shares without reliance upon any express or implied representations or warranties of any nature, whether in writing, orally or otherwise, made by or on behalf of or imputed to TransDigm or any of its Affiliates, except as expressly set forth in this Agreement.
Purchase Agreement § 5.8 (emphasis added), quoted in TransDigm Inc., 2013 WL 2326881 at *7. Buyer argued that Count II of its counterclaim was not based on an extra-contractual representation, but rather on “an intentional and affirmative concealment” of material facts. TransDigm Inc., 2013 WL 2326881 at *8. Sellers, however, argued that the Purchase Agreement’s language barred Buyer’s claims, relying on the authority of a Delaware Supreme Court decision, RAA Management, LLC v. Savage Sport Holdings, Inc., 45 A.3d 107 (Del.2012), which held that non-reliance disclaimers in non-disclosure agreements that barred claims for fraudulent misrepresentations were enforceable.
The court accepted Buyer’s argument, noting that the language in the non-disclosure agreement in RAA Management materially differed from the language in the Purchase Agreement because the relevant provision in the non-disclosure agreement had additional disclaimers not included in the Purchase Agreement, including that the potential acquirer understood and acknowledged “that neither the Company nor any Company Representative is making any representation or warranty, express or implied, as to the accuracy or completeness of the Evaluation Material or of any other information concerning the Company provided or prepared by or for the Company,” and that “[o]nly those representations or warranties that are made to a purchaser in the Sale Agreement when, as and if it is executed, and subject to such limitations and restrictions as may be specified [in] such a Sale Agreement, shall have any legal effect.” TransDigm Inc., 2013 WL 2326881 at *8 (quoting 45 A.3d 107 at 100). In addition, the court observed that although Sellers cited no cases that held that a party to an agreement with language similar to the Purchase Agreement could not recover for the other party’s fraudulent and active concealment of material information, two Delaware Supreme Court cases, which the court relied on in RAA Management, contained language expressly disclaiming reliance on both the omission of information and extra-contractual representations. Id. at *9. In Great Lakes Chemical Corp. v. Pharmacia Corp., 788 A.2d 544 (Del. Ch.2001), the court noted, the buyer represented that “[n]one of [the sellers] make[s] any express or implied representation or warranty as to the accuracy or completeness of the information contained herein or made available in connection with any further investigation of the Company,” and that “[e]ach of [the sellers] expressly disclaims any and all liability that may be based on such information or errors therein or omissions therefrom.” Id. at 552. In re IBP, Inc. Shareholders Litigation, the confidentiality agreement stated that the acquiring company understood and agreed “that none of the Company, its advisors or any of their . . . representatives (i) have made or make any representation or warranty, express or implied, as to the accuracy or completeness of the Evaluation Material or (ii) shall have any liability whatsoever . . . relating to or resulting from the use of the Evaluation Material or any errors therein or omissions therefrom, except in the case of (i) and (ii), to the extent provided in any definitive agreement relating to a Transaction.” In re IBP, Inc. Shareholders Litigation, 789 A.2d 14 (Del. Ch.2001) (quoted in TransDigm Inc., 2013 WL 2326881 at *9).
Ultimately, the court concluded that although Buyer could not have reasonably and justifiably relied on extra-contractual pre-closing representations of the Sellers because of the explicit disclaimer in Section 5.8, Buyer “reasonably could have relied on the assumption that [Sellers were] not actively concealing information that was responsive to [Buyer’s] inquiries and that [Sellers were] not engaged in a scheme to hide information material to [Buyer’s] purchase of Limead.” Id. at *9. Further, the court determined that the language in Section 5.8 “does not clearly disclaim reliance on the type of concealment and omission” that Buyer alleged. Id.
Buyer premised its counterclaim Counts III and IV upon the alleged misleading, or half true, language in the Sellers’ representations and warranties of the Purchase Agreement. Id. at *10. The court found that Buyer could potentially succeed in its misrepresentation claims if it were able to prove that the representations and warranties at issue were “half-truths that caused a false impression as to the true state of affairs.” Id. at *11. Ultimately, however, the court found that Sellers, at most, engaged in misleading negotiation tactics. Id. at *12.
In counterclaim Counts III and IV, Buyer argued that although the misrepresentations took place between October 2009 and October 2010, Buyer nevertheless stated a claim. Id. Buyer took this position, notwithstanding the inclusion of representations and warranties in the Purchase Agreement that specifically referenced (1) changes by scheduled customers or notifications of intentions by scheduled customers to materially change economic terms under which it prepared to purchase from a Fastener Subsidiary since December 31, 2010 and (2) changes or events that had occurred or would be reasonably expected to have a Material Adverse Effect (as defined in the Purchase Agreement) since such date. Id. Buyer, relying on the holding of Norton v. Poplos, 443 A.2d 1 (Del.1982), argued that Sellers had implicitly represented that the Sellers had fully disclosed all material information covered by the representations at issue during the diligence period. In Norton, the Delaware Supreme Court held that “although a statement or assertion may be facially true, it may constitute an actionable misrepresentation if it causes a false impression as to the true state of affairs, and the actor fails to provide qualifying information to cure the mistaken belief.” Id. at 5.
In analyzing the application of the half-truth doctrine to the facts of TransDigm, the court provided several rules that provide guidance to parties that are negotiating purchase agreements. First, the court stated, in dicta, that a half-truth may constitute an actionable misrepresentation, particularly if it causes a false impression. The court cited Airborne Health, Inc. v. Squid Soap, LP, 2010 WL 2836391, at *9 (Del. Ch. July 20, 2010), among other cases, as supporting the proposition that a partial disclosure that is technically true may still be actionably misleading if such partial disclosure “tended to create a false impression.” TransDigm Inc., 2013 WL 2326881 at *11. Second, the court noted that Delaware courts will enforce contractual disclaimers to release claims of fraud when the parties to the agreement are “sophisticated entities” that have “carefully negotiated” the provision. Id. at *11(quoting Progressive Int’l Corp. v. E.I. duPont de Nemours & Co., Inc., 2002 WL 1558382, at *7 & n.36 (Del. Ch. July 9, 2002)).
Ultimately, however, the court found that Buyer could not demonstrate that the representations at issue caused a false impression as to the true state of affairs because Buyer could not conceivably prove that “there were qualifying matters that should have been included with these representations to prevent the implication of a false assertion with respect to other facts.” TransDigm Inc., 2013 WL 2326881 at *11. The language of the date qualification in the representations, the court asserted, was not ambiguous; therefore, Sellers were not obligated to disclose any additional facts to prevent the words of the representations from being misleading. Id. at *12. The court found that the time periods negotiated by the parties reflected the “agreed upon allocation of risk between sophisticated parties.” Id. at *12. While rejecting the Buyer’s counterclaims under Counts III and IV, the court did note, however, that Sellers’ “negotiation tactics may have included an active concealment of material information that was responsive to [Buyer’s] requests for information,” and that Buyer still had the option to pursue its fraudulent concealment claim under Count II of its counterclaims. Id. at *13.
Because Buyer had stated a claim for fraudulent and active concealment of material information, the court determined, Sellers were not entitled to have Count V of Buyer’s counterclaims dismissed since such a dismissal would require that the court dismissed all of the underlying tort claims. Id. at *13.
Importance of Case
TransDigm demonstrates the legal risk sellers take by failing to disclose certain information to buyers during diligence periods or by making representations to buyers during such periods that are not contained within the four corners of their purchase agreements. The case also illustrates, however, that sellers may use certain disclaimers (provided that their purchase agreements incorporate Delaware choice-of-law provisions) to obviate legal liability. The language that the court quotes from the buyer’s representation in Great Lakes Chemical Corp. v. Pharmacia Corp. and the confidentiality agreements in In re IBP, Inc. Shareholders Litigation provides useful guidance for sellers drafting purchase agreements by presenting, respectively, enforceable provisions that disclaim reliance on (1) the omission of information and extra-contractual representations and (2) the accuracy or completeness of the diligence material or omissions from them. Sellers should note, however, that Delaware courts may not enforce such disclaimers when the buyer is not a sophisticated party.
TransDigm also puts buyers on notice that they should carefully examine the language of disclaimers in their purchase agreements governed by Delaware law to determine their exposure to risk that their counterparties have made extra-contractual omissions or commissions during diligence periods. Prospectively, buyers should attempt to reject any such disclaimers or adjust their purchase prices to account for their diminished ability to rely on the responses their counterparties make to buyers’ specific questions during diligence periods. Furthermore, buyers should ensure that their purchase agreements reflect an appropriate allocation of risk between the parties and should appropriately limit any temporal limitations that may apply to sellers’ representations and warranties.