I n Landreth Timber Co. v. Landreth , 471 U.S. 681 Factual - - PDF document

I

n Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985), the Supreme Court ruled that the federal securities laws applied to the sale of a business structured as a stock sale. Since Landreth, there has been a concern that sellers in a stock purchase could be subject to Rule 10b-5 claims notwithstanding the negotiation of specific, limited representations and warranties in the agreement. The recent case of AES

• Corp. v. Dow Chemical Co., Fed. Sec. L. Rep. (CCH)

¶91,515, however, appears to offer sophisticated sellers who choose to structure a proposed transaction as a stock rather than an asset sale a heightened degree of comfort with regard to limiting their exposure to potential Rule 10b-5 claims. In AES, the United States District Court for the District of Delaware upheld contract provisions that sought to limit a purchaser's ability to rely on representations and warranties not specifically set forth in the definitive acquisition documents. Applying a set of factors developed by the Third Circuit to evaluate the reasonableness of a plaintiff's reliance, the court determined that the plaintiff's alleged reliance on representations and warranties not contained in those documents was unreasonable as a matter of law, eliminating a necessary element of the plaintiff's Rule 10b- 5 claim. The court further held that where the transaction at issue involved sophisticated parties negotiating at arm's length, Section 29(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), which invalidates waivers of compliance with the Exchange Act and the rules thereunder, will not bar the enforcement of a waiver of reliance. The case highlights that, if properly structured, potential Rule 10b-5 claims can be eliminated in a stock purchase, at least in transactions involving sophisticated parties.

Corporate Finance Alert

November 2001

Court Upholds Waiver of 10b-5 Claims in Stock Purchase

By: John D. Hogoboom and Desiree K. Holzlein

Factual Background The plaintiff, AES Corp. ("AES"), acquired the stock of a majority owned subsidiary from Dow Chemical ("Dow"). In connection with the proposed transaction, AES executed a confidentiality agreement stating that AES would not rely on any information provided to it during its review of the affairs of the subsidiary other than information contained in specific representations and warranties included in a final purchase agreement. An offering memorandum given to prospective purchasers reiterated this provision, stating that only specific representations and warranties made in a final agreement, if any, would have legal effect. It also contained cautionary disclosure that "statements, estimates, and projections" regarding future performance were based on various assumptions that might not prove to be accurate. The definitive agreement executed by the parties expressly stated that except for the representations and warranties it contained, neither the parties nor any other person had made any express or implied representations or warranties on their behalf. It also provided that the agreement and confidentiality agreement (and certain unrelated agreements) constituted the entire agreement of the parties and superseded all prior agreements or understandings with respect to the transactions. The agreement included no representations or warranties regarding projections for the subsidiary. Rule 10b-5 Claims Subsequent to the purchase, AES filed suit against Dow asserting that Dow had violated Rule 10b-5 by misrepresenting the future prospects of the subsidiary, directly causing AES's valuation of the

This document is published by Lowenstein Sandler PC to keep clients and friends informed about current issues. It is intended to provide general information only. 65 Livingston Avenue www.lowenstein.com

L

Roseland, New Jersey 07068-1791 Telephone 973.597.2500 Fax 973.597.2400

G

subsidiary to be inflated by at least $70 million. Dow moved for summary judgment arguing that AES's reliance on any representations not contained in the definitive agreement was unreasonable as a matter

• f law in light of the various provisions described

above and the fact that none of the alleged misrepresentations were contained in the definitive agreements. Section 10(b) of the Exchange Act prohibits the use of manipulative and deceptive devices in connection with the purchase or sale of a security. Rule 10b-5 makes it unlawful: "(1) to employ any device, scheme, or artifice to defraud, (2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of a security." To prove a violation of Rule 10b- 5, a plaintiff must show that the alleged violator: "(1) made a misstatement or an omission of a material fact (2) with scienter (3) in connection with the purchase or sale of a security (4) upon which [p]laintiff reasonable relied and (5) that [p]laintiff's reliance was the proximate cause of [p]laintiff's injury." Semerenko v. Cendant Corp., 223 F.3d 165, 174 (3d Cir. 2000). Reasonableness of Reliance In the Third Circuit, the determination of whether reliance is reasonable is based on five factors set forth in Straub v. Vaisman & Co., 540 F.2d 591 (3d Cir. 1976): (1) the existence of a fiduciary relationship; (2) the plaintiff's opportunity to detect the fraud; (3) the plaintiff's level of sophistication; (4) the existence of a longstanding business or personal relationship; and (5) access to the relevant

• information. See id. at 598. Applying the Straub

factors, the AES court found that the plaintiff's reliance on representations not contained in the final transaction documents was unreasonable as a matter of law because: (1) Dow had no fiduciary relationship with AES, (2) AES had ample

• pportunity to detect the alleged fraud and access to

all relevant information, (3) AES did not allege the existence of any long-term business or personal relationship, and (4) AES was a sophisticated party that was represented by outside counsel in the transaction. In support of its motion for summary judgment, Dow relied on several decisions that upheld the enforceability of written disclaimers of reliance on representations not contained in the definitive

• agreements. In Rissman v. Rissman, 213 F.3d 381 (7th
• Cir. 2000), a former minority shareholder sued the

majority shareholder for securities fraud after the majority shareholder sold the company at a price much higher than that which the plaintiff had received for his shares. The plaintiff alleged that the defendant had "fraudulently induced him to sell his stock by assuring him that [the company] would not be sold." The defendant, however, had refused to represent that he would not sell the company. Further, the plaintiff had represented in the stock sale that he would not rely on statements previously made by the defendant. The Seventh Circuit granted summary judgment for the defendant, holding that "a written anti-reliance clause precludes any claim of deceit by prior representations." Id. at 384. In Harsco Corp. v. Segui, 91 F.3d 337 (2d Cir. 1996), the Second Circuit held that a stock purchaser could not maintain a Rule 10b-5 claim based on a representation not contained in the final agreement. In Harsco, the parties' definitive agreement contained fourteen pages of representations and warranties, a statement that the sellers did not make any representation or warranty other than those specifically made in the written agreement itself and a provision stating that the agreement contained the entire agreement of the parties. In holding for the defendant, the court stressed that the definitive agreement was a detailed writing that had been negotiated by sophisticated parties with the aid of advisors. Similarly, in Jackvony v. Riht Fin. Corp., 873 F.2d 411 (1st Cir. 1989), the First Circuit held that the plaintiff could not rely on statements made outside a definitive purchase agreement and a related proxy

G

statement which contained a disclaimer of representations and warranties not explicitly made in the final agreement. The final agreement contained a merger clause stating that it contained the entire agreement of the parties. In deciding that plaintiff's reliance on certain oral representations was unreasonable, the court emphasized the sophistication of the plaintiff, noting that the plaintiff had helped to draft the acquisition documents and that the proxy statement instructed the plaintiff not to rely on statements made outside

• f the final agreement.

In One-on-One Enters., Inc. v. Caruso, 848 F.2d 1283 (D.C. Cir. 1988), the D.C. Circuit held that reliance by the plaintiffs on representations outside the final transaction documents was unreasonable because the final agreement contained a merger clause stating that the agreement "superced[ed] [sic] any and all previous understandings and agreements." Id. at 1286. The court noted that the parties had painstakingly negotiated the transaction for eight months, that the final agreement was "lengthy, detailed and comprehensive," and that the parties had specifically included the merger clause "to make clear that the only understanding between the parties was that expressed in the Agreement." Id. Effect of Section 29(a) of the Exchange Act AES attempted to avoid the holdings of these cases by arguing that the non-reliance and merger clauses contained in the transaction documents violated Section 29(a) of the Exchange Act which provides that: "Any condition, stipulation, or provision binding any person to waive compliance with any provision of this chapter or of any rule or regulation thereunder, or of any rule of an exchange required thereby shall be void". In support of its argument, AES cited Rogen v. Ilikon Corp., 361 F.2d 260 (1st Cir. 1966) in which the First Circuit used Section 29(a) to invalidate a contractual acknowledgment of non-reliance. In Rogen, the plaintiff was an individual shareholder who sued the defendant company alleging he was fraudulently induced to sell his stock to the company by its failure to disclose favorable information concerning its

• profits. The Rogen court held that Section 29(a) of

the Exchange Act rendered void a provision in the parties' stock sale agreement stating that the plaintiff "'[was] fully familiar with the business and prospects

• f the corporation, [was] not relying on any

representations or obligations to make full disclosure with respect thereto, and [has] made such investigation thereof as [plaintiff] deem[s] necessary.'"

• Id. at 265. It reasoned: "Were we to hold that the

existence of this provision constituted the basis (or a substantial part of the basis) for finding non-reliance as a matter of law, we would have gone far toward eviscerating Section 29(a)." Id. at 268. Section 29(a) also was raised as a defense in the Harsco case. However, the Harsco court declined to follow Rogen. The Harsco court pointed out that the plaintiff in Rogen could be considered "overtrusting" and emphasized the disparity in bargaining power between the individual plaintiff and defendant

• corporation. By contrast, the parties in Harsco were

sophisticated and well represented. Further, the Harsco court ruled that Section 29(a) did not bar enforcement of the waiver of reliance because the plaintiff had not "waived its rights to bring any suit resulting from th[e] deal" and had, in fact, "vigorously defined those rights" in the "fourteen pages of representations, any of which, if fraudulent, [could have been] the basis of a fraud action against the sellers." Id. at 344. The AES court found that its facts more closely resembled Harsco than Rogen and that the reasoning

• f the Harsco court was more persuasive on the

question of whether the waiver of reliance violated Section 29(a). In support of its decision, the court noted that AES and Dow were sophisticated "Fortune 500"companies that negotiated the terms and documentation of the transaction at arm's length. It also pointed out that the final merger agreement was comprehensive, including more than twenty pages of representations and warranties. Determining that Harsco and the later cases applied "squarely" to the facts before it, the AES court held that AES's waiver

• f reliance was enforceable. It emphasized that "the

agreements at issue were negotiated by sophisticated parties at arm's length" and declared that "[w]hen transacting business, [substantial] companies must be

G

representations and warranties contained in the definitive agreement to make sure the agreement appropriately addresses the purchasers' concerns regarding the business. The AES case also highlights the importance of having sophisticated counsel involved in both sides of the sale transaction and the dangers that lurk if transactions are not appropriately

• documented. However, AES leaves other questions
• pen for another day. For instance, an agreement

which limits damages for breach of warranty may, under the reasoning of AES, be unenforceable under Section 29(a). An express waiver of 10b-5 liability in connection with the sale also may be unenforceable, although experienced counsel will be able to arrive at the same result through the methods employed in AES. Please feel free to contact either John D. Hogoboom, Member of the M&A and Corporate Finance Practice Group, at (973) 597-2382 or Desiree K. Holzlein, an Associate in the Group, at (973) 422-6416 if you have any questions or would like further information. able to rely on the written words of their agreements." The court concluded that "in these circumstances . . . Section 29(a) . . . does not bar the enforcement of a clause disclaiming representations and warranties not appearing in a final agreement negotiated between sophisticated parties in an arm's length transaction." Accordingly, the court granted Dow's motion for summary judgment. Impact of the AES Decision To limit its exposure to potential Rule 10-5 claims, a seller entering into an agreement for the sale of stock must take care that the documentation for the sale includes appropriate limitations regarding the scope of the representations and warranties

• made. Further, confidentiality agreements should be

in place prior to exchanging information, and such agreements should make clear that the buyer is entitled to rely only on those representations and warranties contained in the final agreement. Conversely, purchasers should carefully review the

G