M&A case law: PE seller liable on the grounds of fraud by its portfolio company’s CFO

The SPA between the seller and the purchaser contained liability limitation provisions, one of which was that the purchaser’s sole recourse for breaches of business warranties was to its W&I insurance, except in the case of fraud by the seller. One of the key questions to be answered by the NCC was whether the fraud committed by the target's CFO could be attributed to the seller.

Dutch law standards for attribution of knowledge and actions

To answer this question, the court referred to established case law from the Dutch Supreme Court on the doctrine regarding the attribution of actions and knowledge. According to this doctrine, the actions and knowledge of a manager of a legal entity may be attributed to that legal entity if, by standards prevalent in the community (maatschappelijke opvattingen), such actions or knowledge must be regarded as the entity’s own. Relevant aspects in establishing whether this is the case are whether the manager has a “duty to communicate” his or her actions or knowledge to the legal entity and whether the legal entity has a “duty to enquire” regarding the information needed to fulfil its duties.

This standard has also been applied in the context of a corporate group, whereby knowledge of a manager may be attributed to a legal entity even if the individual was not a manager of that entity, provided that by standards prevalent in the community such knowledge should be deemed to be the entity's own.

Application by the NCC

In the present case, the NCC concluded that the actions and knowledge of the CFO of the seller’s portfolio company were attributable to the seller. It appears that this was mainly the case because the seller was the group’s parent company, involved in the M&A transaction, and the CFO was aware of the M&A transaction.

In addition, the NCC also considered it relevant that the SPA defined “knowledge of the seller” to include the CFO's knowledge. This definition served only to qualify the warranties and was not used in the context of the “fraud exception”, but the NCC nevertheless stated that this definition “does not help the seller”. Although it does not follow from the ruling whether this has been argued by the seller, the definition of ‘knowledge’ can also be used to argue the opposite. Only in relation to qualifying the warranties did the parties explicitly agree to attribute the CFO’s knowledge to the seller; they did not agree to include the same in relation to the “fraud exception”. On this basis, the NCC could possibly also have used the SPA clauses as substantiation that the CFO’s fraud should not be attributed to the seller.

Furthermore, the NCC views an outcome whereby only the seller’s own directors and officers could be considered for attribution of knowledge/actions to be unworkable in the context of an M&A transaction. In its view, this “would obviously create moral hazards and perverse incentives, and undermine the integrity of the M&A process”. The NCC seems to disregard the fact that individuals acting fraudulently can also be held liable for their own actions, which should already be an incentive to avoid reckless fraudulent behaviour by such individuals.

Separately, although the NCC also references the seller’s “duty to enquire” as an additional ground for attribution of knowledge, it does not substantiate whether and how the seller failed to enquire about the relevant information underlying the warranty breaches and how it could have complied with that duty (e.g. by obtaining confirmation from the CFO that the information provided was accurate).

Takeaways

One of the key takeaways from this ruling for a seller is that even if it has negotiated tight liability provisions with limited to no recourse, this does not necessarily mean it will be off the hook in all cases. Actions taken by, or knowledge of, managers of its portfolio companies may be attributed to the seller, thereby creating potentially unexpected loopholes in the liability regime. However, the criteria applied by the NCC in arriving at its conclusion provide limited guidance as to when this is the case.

This case illustrates that information asymmetry between a seller and its portfolio company’s management bears potential liability risks that sellers should aim to mitigate, including by being closely involved in the M&A and information-sharing process. Sellers may also want to consider including even more specific provisions in transaction documentation regarding the extent to which information and knowledge should be attributed to a seller and under which circumstances.

Although the NCC ruled that the seller was liable for the purchaser’s damage, it remains to be seen whether the purchaser will actually be able to retrieve its losses. If the seller has negotiated with the purchaser that the purchaser's sole recourse for business warranties is to its W&I insurance, it is not uncommon for the seller to refrain from providing additional security. If the selling entity is a special purpose vehicle with limited or no other assets, it may prove challenging for the purchaser to actually recover its losses from that entity.