Fraud Carve-Outs and the Unintended Consequences of Reliance Disclaimers in M&A Transactions

Delaware and New York courts routinely uphold reliance disclaimers to limit representations and warranties forming the basis of an M&A agreement to those expressly stated in the contract. M&A agreements often contain various forms of fraud carve-outs, providing that limitations in the contract apply “except in cases of fraud.” Recent court trends counsel caution in agreeing to reliance disclaimers and recognize the validity of strong fraud carve-outs in M&A agreements.

A 2016 decision by the Delaware Superior Court – JCM Innovation Corporation v. FL Acquisition Holdings, Inc. – provides a basis for a defrauded buyer to argue that strong fraud carve-outs should control over contractual limitations on remedies, including reliance disclaimers. The court allowed fraud claims to proceed, highlighting a fraud carve-out in the reliance disclaimer that preserved “any rights that Purchaser has with respect to . . . any intentional misconduct by Seller.”

The only legitimate basis for inclusion of a reliance disclaimer is avoidance of litigation costs in the event of non-meritorious fraud claims. If a seller complains about litigation risk/cost, consider agreeing to limited threshold Alternative Dispute Resolution at the pleading stage as a condition precedent to litigation. This will mitigate any legitimate concern that remorseful buyers will be able to press meritless fraud claims through expensive discovery. Buyers should avoid the unintended consequences of reliance disclaimers by including strong fraud carve-outs in their merger agreements, and resisting the inclusion of unchecked reliance disclaimers.