

Robert Miller —  7 September 2007

Last week the Second Circuit Court of Appeals decided Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc. (available here), which involved fraudulent inducement and breach of warranty claims in connection with a business combination agreement. The case is a straightforward application of familiar principles of blackletter law. I mention it because of certain highly unusual provisions in the purchase agreement between the parties.

First, some background. Back in 2000, Allegheny was considering purchasing GEM, a subsidiary of Merrill involved in trading energy commodities. In connection with Alleghenyâ€™s due diligence review, Merrill provided Allegheny with a great deal of information about GEM. The opinion doesnâ€™t say what happened in this case, but usually such information is delivered under a confidentiality agreement that provides not only that the potential buyer will not disclose the information but also that the potential seller makes no representations or warranties as to the completeness or accuracy of the information provided. Such a disclaimer makes perfect sense. The materials being produced are the business records of the seller, and they were generated in the ordinary course of running the company, not to be relied on by third parties with interests adverse to those of the seller. The efficient error rate for business records is presumably much higher than the efficient error rate for contractual representations, breaches of which will almost inevitably subject the person making them to liability. Hence, if the seller represented that materials produced in due diligence were, say, â€œtrue and complete in all material respects,â€ this representation would very likely be false. The usual thing, therefore, is for the seller to make no representations or warranties on such materials.

Merrill and Allegheny eventually entered into a definitive purchase agreement for the sale of GEM, and this agreement, like virtually all business combination agreements, included elaborate representations and warranties by the seller about the condition of the business. This too makes sense. Limiting representations to ones expressly made in the agreement reduces uncertainty and forces the parties to bargain over exactly which representations will be made.


A disappointed buyer like Allegheny can make either or both of two claims. It can argue fraudulent inducement, and so have to prove that the seller knowingly (or recklessly) included false information in the due diligence materials and that the buyer justifiably relied on such information to its detriment. Or, the buyer can argue breach of warranty, and so have to prove that the seller made a false statement in the representations in the agreement and the buyer was harmed thereby. In the first case, the universe of relevant statements is much wider, but the buyer has to prove not only that one such statement was false but also that the seller made the false statement knowing it was false (or in reckless disregard of its truth). In the second, the universe of relevant statements is confined to those made in the agreement, but all the buyer has to prove is that one such statement was false; the sellerâ€™s knowledge of its falsity is irrelevant.

The agreement between Merrill and Allegheny, however, contained some highly unusual provisions. In particular, Merrill warranted that the information provided to Allegheny â€œin the aggregate, in [Merrillâ€™s] reasonable judgment exercised in good faith, is appropriate for [Allegheny] to evaluate [GEMâ€™s] trading positions and trading operations.â€ This should take the breadth away from any practicing M&A lawyer. In effect, Merrill is representing not only that it believed the information provided in due diligence was true but also that it reasonably believed such information was true. Hence, any false statement in the diligence materials becomes potentially actionable: the seller will argue that Merrill should reasonably have known such statement was false.

Even worse, Merrill is representing that the information it provided was â€œappropriateâ€ for Alleghenyâ€™s evaluating the business. At the very least, this means that Merrill is warranting that it reasonably believed that it delivered all the information that Allegheny needed to value the business. Hence, omissions from due diligence will become actionable. If Merrill had any information it did not produce to Allegheny in due diligence, Allegheny will now argue that such information was reasonably necessary for it to value the business and so its non-delivery to Allegheny was a breach.

Moreover, representing about whether the materials produced were â€œappropriateâ€ for valuing the business also requires Merrill to make judgments about what information a buyer reasonably needs in a valuation study and so involve making judgments about what were appropriate valuation methodologies for the business in question. That, quite simply, is not the sellerâ€™s job. How the buyer values the business is something only the buyer can really know. After deciding how to value the business, the buyer should ask for what information it needs, and, even better, bargain for representations in the agreement concerning that information.

Not surprisingly, the Second Circuit reversed the district courtâ€™s summary judgment in favor of Merrill and remanded for further proceedings. The lesson hereâ€”besides the obvious one that Merrill cut a very bad deal and should hire better lawyersâ€”is that representations should be about matters of fact the seller can be fairly certain it knows to be true, not normative judgments about whatâ€™s â€œappropriate,â€ especially from the point of view of an adverse party. Voluntary exchanges are efficient because each of the parties prefers the result of the exchange to the status quo ante. A representation by one party that the other party has evaluated the change correctlyâ€”i.e., â€œreallyâ€ prefers itâ€”is beyond what that party could know. Giving such a representation almost amounts to insuring the transaction for the other party. Merrill, I suspect, did not realize that it was doing that, but the result follows from the contract language, and the Second Circuit quite properly is holding Merrill to the bargain it struck.