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Due diligence in a privately negotiated acquisition transaction is an inherently imprecise process. The target company may not be subject to public reporting requirements under the federal securities laws and thus may be unaccustomed to the legal rigors of a disclosure regimen. Additionally, because a buyer relies on potential future performance to assess value, projections and other “soft” information usually are shared. In a typical transaction undertaken between sophisticated parties, the seller will not make any representation or warranty with respect to much of the information provided in the due diligence exercise, and absent actual fraud, the onus will be on the buyer to seek specific comfort where appropriate and otherwise exercise its best judgment as to the veracity of the information provided. However, the seller’s legal exposure for information provided in an acquisition transaction is not necessarily limited to the statements made in the contract. If buyer’s remorse sets in after closing for whatever reason, the disaffected buyer may assert federal securities laws claims (in stock purchase transactions) [FOOTNOTE 1] and state law fraud and negligent misrepresentation claims (in both stock and asset purchases) based on information shared during diligence that later proves inaccurate through no fault of the seller. As a result, the definitive agreements typically will include detailed representations and warranties specifying the information on which the buyer relied as well as a “non-reliance” provision pursuant to which the buyer disclaims reliance on any other information. This approach facilitates a full and open due diligence process by specifically allocating risk between the buyer and the seller regarding the information used by the buyer to make its investment decision. ‘HARSCO’ The 2nd U.S. Circuit Court of Appeals recognized the efficacy of this arrangement in Harsco Corp. v. Segui, [FOOTNOTE 2] where the court held that detailed representations and warranties coupled with non-reliance provisions preclude both state and federal fraud claims against sellers based on extra-contractual statements. There, the purchase agreement contained lengthy and detailed representations and warranties, conditioned the closing of the transaction on the buyer’s completion of “confirmatory due diligence,” and included a specific disclaimer of reliance by the buyer with respect to all statements other than those set forth in the agreement. Notwithstanding these provisions, the buyer brought suit alleging violations of Rule 10b-5 under the Exchange Act as well as common-law fraud and misrepresentation claims, based on, among other things, statements made by the sellers during due diligence that were not included in the purchase agreement. In upholding the dismissal of the buyer’s complaint, the 2nd Circuit held that the non-reliance provision in the purchase agreement precluded the buyer from establishing “reasonable reliance” on the sellers’ extra-contractual statements, a required element of a fraud or misrepresentation claim under both federal and state law. [FOOTNOTE 3] In reaching that result, the court rejected the contention that the reliance disclaimer violated � 29(a) of the Exchange Act, which states that “any … provision … binding any person to waive compliance with any provision of [the Exchange Act] or of any rule or regulation thereunder … shall be void.” The court acknowledged that the agreement “weakened” the buyer’s ability to prevail on an Exchange Act claim, but determined that it “[did] not constitute a forbidden waiver of compliance.” Plaintiff was not prevented from bringing suit; rather, the court concluded that the non-reliance provision together with the representations and warranties merely specified the information on which plaintiff relied and therefore the information on which any fraud or misrepresentation claim could be based. The court characterized the agreement as “a detailed writing developed via negotiations among sophisticated business entities and their advisors. That writing … defines the boundaries of the transaction. [The buyer] brings this suit principally alleging conduct that falls outside those boundaries.” ‘CON ED’ A similar result was reached this in March by the U.S. District Court for the Northern District of New York in dismissing the common-law fraud claims arising out of the aborted Consolidated Edison/Northeast Utilities merger. [FOOTNOTE 4] In that case, Con Ed refused to proceed with an agreed upon merger with NU alleging, among other things, that during the due diligence process officers of NU made misleading statements regarding certain NU risk management policies. The court held that, under New York law, Con Ed could not establish reasonable reliance on such statements. In reaching its conclusion, the court relied on the relatively typical provision in the parties’ confidentiality agreement to the effect that no representation or warranty would be made by either party regarding the accuracy of information exchanged during due diligence and that the parties were not entitled to rely on the accuracy or completeness of such information. The confidentiality agreement further stated that “only those representations and warranties made in a Definitive Agreement … will have any legal effect.” The court noted that there were no representations or warranties relating to the NU risk management policies in the definitive merger agreement, and accordingly, Con Ed could not bring a fraud claim with respect to any statements regarding such policies. ANOTHER CONCLUSION Last month, however, in AES Corp. v. Dow Chemical Co., [FOOTNOTE 5] the 3rd U.S. Circuit Court of Appeals came to a different and potentially troubling conclusion. AES had purchased all of the stock of a Dow subsidiary whose sole asset was a contract to design and construct a power plant in the Netherlands. As in the Con Ed case, the confidentiality agreement included a standard acknowledgment by AES that it was not entitled to rely on the accuracy of any information provided during due diligence, and it further provided that in deciding to proceed with a transaction AES would rely solely on the representations and warranties made in the definitive transaction agreements. Those agreements stated that except for the representations and warranties included therein, the sellers made no other express or implied representation or warranty. When AES realized that completion of the power plant would cost substantially more than its due diligence had indicated, it brought suit alleging that Dow was aware of specific facts that contradicted statements made during due diligence. As in Harsco and Con Ed, the allegedly fraudulent statements at issue were not included in the representations and warranties made in the final transaction agreements. In reversing a grant of summary judgment for the defendants, the 3rd Circuit determined that the language of the confidentiality agreement and definitive transaction documents did not bar AES from demonstrating the reasonable reliance on the seller’s extra-contractual statements necessary to establish its Rule 10b-5 claim. The court reasoned that a promise not to rely on any specific statement itself constitutes a waiver of rights under the Exchange Act in violation of � 29(a). According to the opinion, “the scope of the anticipatory waiver is … limited, but it is nevertheless an anticipatory waiver of potential future claims under Rule 10b-5.” In rejecting the reasoning of Harsco, the court stated that � 29(a) “expressly forecloses parties from ‘defin[ing] the boundaries of the[ir] transaction’ in a way that relieves a party of the duties imposed by” the Exchange Act. [FOOTNOTE 6] The AES court, however, did not nullify the non-reliance clauses completely, and instead held that, rather than a bar to Rule 10b-5 claims, such clauses may serve as “some evidence of an absence of reliance.” In connection with weighing the evidentiary value of a non-reliance clause, the 3rd Circuit instructed that in situations where a seller is unwilling to vouch for the accuracy of the information provided to a potential buyer, “a buyer who relies on seller-provided information without seeking to verify it has not acted reasonably.” The court remanded the action to the district court to resolve the factual question of reasonable reliance further noting that “a buyer in a non-reliance clause case will have to show more to justify its reliance than would a buyer in the absence of such a contractual provision.” [FOOTNOTE 7] Whether a sophisticated buyer can possibly carry that burden in the face of explicit contractual language to the contrary remains to be seen. MEASURES TO CONSIDER Pending further analysis of the factual question, practitioners may wish to consider certain additional protective measures in connection with representing sellers in acquisition transactions: � In confidentiality agreements and transaction documents, seller’s counsel should consider including provisions requiring that New York law apply and that any action relating to the agreement be brought within New York, and if permissible under jurisdictional constraints, in a federal court. Although application of New York law will not affect federal securities claims, as illustrated by the Con Ed decision, it will ensure that a non-reliance provision will have the maximum possible effect with respect to common-law claims. Also, laying venue in New York likely will allow a seller to take advantage of the 2nd Circuit’s view with respect to the limited effect of � 29(a) of the Exchange Act. � In any case, care should be exercised by seller’s counsel in the drafting of non-reliance and related provisions in case the 3rd Circuit’s view is applied. In order to maximize the evidentiary effect of non-reliance provisions the relevant provisions should include an express acknowledgment by the buyer that it is sophisticated in commercial matters, it has had an adequate opportunity to conduct an investigation of the seller, and as a result, it has relied solely on the statements set forth in the relevant agreements in making its investment decision. � Sellers may seek to rely more heavily on the use of indemnity caps and limited escrows to protect against liability. However, the extent to which the AES opinion may restrict the efficacy of such limitations as a partial waiver of securities law liability is unclear. Paul J. Shim and David Leinwand are corporate partners at Cleary, Gottlieb, Steen & Hamilton (www.clearygottlieb.com). ::::FOOTNOTES:::: FN 1 See Gustafson v. Alloyd Co., 513 U.S. 561 (1995). FN 2 91 F.3d 337 (2d Cir. 1996). FN 3 “To state a valid claim under Rule 10b-5, a plaintiff must show that the defendant (1) made a misstatement or an omission of a material fact (2) with scienter (3) in connection with the purchase or the sale of a security (4) upon which the plaintiff reasonably relied and (5) that the plaintiff’s reliance was the proximate cause of his or her injury.” Semerenko v. Cendant Corp., 223 F.3d 165, 174 (3d Cir. 2000). FN 4 Consolidated Edison, Inc. v. Northeast Utilities, 249 F. Supp. 2d 837 (S.D.N.Y. 2003). FN 5 325 F.3d 174 (3d. Cir. 2003). FN 6 Id. at 183 (quoting Harsco, 91 F.3d at 344). FN 7 Id. at 181. AES did not directly address the effect of non-reliance clauses on common-law claims. 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