A recent Third Circuit case casts doubt as to whether a seller can shield itself from securities law fraud claims through a typical "non-reliance" clause. The case is important because it went against a line of decisions in the Second Circuit. The Third Circuit encompasses Delaware while the Second Circuit encompasses New York.

Certain anti-fraud provisions of the federal securities laws, most prominently Rule 10b-5 under the Securities Exchange Act of 1934, apply to the sale of securities, including a disposition of a business if the transaction is structured as a stock sale. The federal securities anti-fraud provisions apply even if the transaction involves the sale of all or some of the stock of a non-public, privately held company. As a result, an unhappy buyer seeking remedies in a stock purchase transaction will often try to bring a securities fraud claim against the seller in addition to any available contract or common law claims based on breach of warranty, fraud or negligent misrepresentation. The remedies under Rule 10b-5 include damages, and more importantly, potential rescission of the transaction. Accordingly, the threat of a federal securities claim lends significant leverage to a disgruntled buyer in settlement negotiations.

The claims based on Rule 10b-5 and related provisions generally allege that the seller or its agents provided misleading information or omitted material information about the business's historical operations or prospects either as part of the pre-sale auction and due diligence process or in the purchase agreement itself. Rule 10b-5 requires the buyer to demonstrate that the seller made a misstatement or omission of material fact, with intent, upon which the buyer reasonably relied, causing the buyer's injury.

A typical "non-reliance" clause is intended to limit a buyer's ability to make a Rule 10b-5 claim by prohibiting the buyer's reliance on information not explicitly included or incorporated in the purchase agreement itself. By doing so, the seller intends to make it impossible to satisfy the reasonable reliance element of a Rule 10b-5 claim. An abridged version of a non-reliance provision might read:

Each of the parties acknowledges that (i) there are no representations or warranties other than those expressly set forth in this Agreement; and (ii) no party has relied or will rely in respect of this Agreement or the transactions contemplated hereby upon any document or written or oral information previously furnished to or discovered by it, other than this Agreement, including the schedules hereto. Seller will not have or be subject to any liability to Buyer or any other person resulting from the distribution to Buyer, or Buyer's use of, any information not contained in this Agreement (including, without limitation, any offering memorandum provided to Buyer).

The AES Case In AES v. Dow Chemical Co., the Third Circuit ruled that a seller cannot use a non-reliance clause in a stock purchase agreement to bar a buyer's securities fraud claim in connection with the sale of a business. The court held that Section 29(a) of the Exchange Act prohibits anticipatory waivers of a seller's obligations under the Exchange Act, including the obligation to comply with Rule 10b-5 and therefore, a non-reliance clause cannot act as a waiver of a seller's obligations to not make any omissions or misstatements of a material fact.

AES Corporation brought a Rule 10b-5 claim against Dow Chemical Company in connection with its purchase of one of Dow's subsidiaries in a stock transaction. The subsidiary had only one asset, a contract to design and build a power plant in the Netherlands. AES claimed that after the closing it realized the plant would cost far more to complete and be ready for operation much later than Dow represented during the negotiations. According to AES, Dow provided it with projections and other data during AES' due diligence investigation but withheld the data that would have tipped off AES to the reality regarding the construction of the plant.

Despite the presence of a non-reliance clause in the agreement limiting AES' reliance only to the representations provided in the agreement, AES claimed that Dow violated Rule 10b-5 and that AES could not waive in advance Dow's obligations under that Rule. Dow argued, and the lower court accepted, that AES' alleged reliance on representations by Dow made outside of the purchase agreement was unreasonable as a result of AES' contractual commitment not to rely on any representations other than those stated in the agreement itself.

The Third Circuit reversed the lower court and held that a seller cannot use a non-reliance clause to prevent the buyer from bringing a securities fraud claim in a stock transaction. The AES court explained that it would offend Section 29(a) to bar the buyer's claim based solely on the contractual commitment not to claim reliance. The AES court rejected the holding of the Second Circuit in Harsco Corp. v. Segui (that a non-reliance clause is not a forbidden waiver because it merely weakens a buyer's claim but does not waive the claim) stating "Section 29(a) is not intended to protect substantive rights created by contract. It is designed to protect rights created by the Exchange Act, and it expressly forecloses contracting parties from 'defin[ing] the boundaries of the[ir] transaction' in a way that relieves a party of the duties imposed by the Act."

It should be noted however, that in making its ruling, the Third Circuit explicitly acknowledged that non-reliance clauses are some evidence of an absence of reliance. The court stated that a plaintiff's declaration in a contract of an intent not to rely may be evidence that he or she did not rely on the representations of the defendants. The court further stated that such a "declaration, alone or in conjunction with other evidence of non-reliance, may establish an absence of reliance and, when unrebutted, may even provide a basis for summary judgment in the defendant's favor." The court ruled that although non-reliance clauses will not provide immunity from Rule 10b-5 fraud liability claims, they are not void and can act as evidence of a party's non-reliance on statements made outside of the definitive agreement.

In contrast, the Second Circuit in Harsco held that sophisticated parties to a transaction may agree to preclude a 10b-5 claim based on representations not made in the definitive agreement and explicitly disclaimed in a non-reliance clause. Harsco Corporation sued various former officers and shareholders of MultiServ under Rule 10b-5. Harsco claimed that MultiServ made various misstatements during due diligence regarding projected business activity and expected developments in the business. Despite the fact that the parties entered into a purchase agreement that was subject to confirmatory due diligence, provided for extensive representations and included a non-reliance clause and a merger clause, Harsco argued that the non-reliance and merger clauses of the agreement should not bar establishing a claim under Rule 10b-5 in reasonable reliance on representations allegedly made by the sellers outside of the contract.

The Harsco court focused on whether the non-reliance and merger clauses so weakened Harsco's ability to recover under Rule 10b-5 that it was prohibited by Section 29(a). While acknowledging some weakening, the court concluded that the non-reliance clause did not rise to the level of a forbidden waiver. The court noted the purchase agreement represented a detailed writing developed through elaborate negotiation between sophisticated parties. The court held that Harsco, without a disparity in bargaining power, essentially purchased 14 pages of representations made by the seller in the purchase agreement. Harsco did not waive its Rule 10b-5 claims but merely limited to the representations in the agreement the bases upon which its 10b-5 action could be brought. Despite its ruling, the Harsco court did note that "this analysis becomes a question of degree and context... In different circumstances (e.g., if there were but one vague seller's representation) a 'no other representations' clause might be toothless and run afoul of [the] § 29(a)" prohibition against anticipatory waivers of obligations under the securities laws.

Based upon the foregoing, we offer the following suggestions to parties contemplating stock purchase or sale transactions in the near future:

Seller

A seller should seek to limit the opportunity of a buyer to bring a Rule 10b-5 claim along with its attendant potential recourse of rescission. In order to limit a buyer's opportunity to bring such a claim, a seller should:

• consider an asset sale, rather than a stock sale. A seller should, however, be aware of the numerous issues implicated by an asset sale, such as tax, contractual consents and more burdensome conveyancing mechanics. Such a structure would not preclude a buyer from bringing a common law claim of fraud against the seller, although these claims may often require an affirmative misrepresentation (rather than an "omission") and may be harder to prove than a Rule 10b-5 claim due to a higher "intent" standard in some jurisdictions;
• consider the impact of the venue and jurisdiction provisions in the purchase agreement and their effect on the ability to rely on a non-reliance clause. Agreeing that the exclusive venue and jurisdiction is New York would take advantage of the Second Circuit's ruling in Harsco and improve a seller's chances of shielding itself from liability by inclusion of the non-reliance clause;
• continue to use disclaimer and non-reliance clauses in sales documents, confidentiality agreements and other due diligence documents, while recognizing the limitations of boilerplate disclaimers. The Harsco court ruled that an agreement with a non-reliance clause in conjunction with only one representation would vitiate the benefit of the non-reliance clause;
• include a non-reliance clause in the purchase agreement and customize it to the sensitivities of the deal. Because many of the cases in this area involve forward-looking information in the marketing materials, specifically identify in the non-reliance clause this material and other documents which are not to be relied upon by the buyer. At a minimum this will strengthen the evidentiary record for non-reliance; and
• include a clear merger clause in the purchase agreement that excludes all other agreements or understandings. Also review carefully all disclosure schedules to the agreement to ensure the disclosures are responsive to the representations but do not inadvertently incorporate information from outside the agreement including any offering documents.

Buyer

In contrast, a buyer should seek to expand its ability to bring a Rule 10b-5 claim along with its attendant potential recourse of rescission. In order to give a buyer the best ability to bring such a claim, a buyer should:

• consider the benefits of a stock sale, rather than an asset sale, to take advantage of the protections of the anti-fraud provisions of the Securities laws. There are, however, other aspects to consider, such as liability issues and tax matters which may outweigh any other advantages;
• consider insisting on a seller's 10b-5 representation (that it has not made any material misstatements or omitted any material information) to obtain the benefit in the purchase agreement of a securities fraud standard;
• not agree to a non-reliance clause in the purchase agreement or exclude fraud/negligent misrepresentation or specific items of concern from such a clause;
• be comfortable with the results of the due diligence and the extent of the representations provided by the seller. The buyer should note that even if it is able to bring a Rule 10b-5 claim, the non-reliance clause may still be evidence that the seller did not rely on any information outside of the agreement; and
• consider the impact of the venue and jurisdiction provisions in the purchase agreement and their effect on the seller's ability to rely on a non-reliance clause. Agreeing that the exclusive venue and jurisdiction is Delaware would take advantage of the Third Circuit's ruling in AES and improve a buyer's ability to claim a Rule 10b-5 violation.

The foregoing is meant as a summary only and should not be used as a substitute for obtaining competent legal counsel. If you would like to discuss the foregoing, please contact Ted Tashlik or Martin Goldwyn.