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Rule 10b-5 and Business Combination Transactions

Professor Miller recently published an article in the University of Pennsylvania Journal of Business Law, titled “Rule 10b-5 and Business Combination Transactions.”

From the abstract:

Parties to large business combination transactions are paradigmatically sophisticated, profit-maximizing entities. As such, they structure their transactions to be efficient, that is, to maximize the joint surplus of the transaction, as this creates the greatest opportunity for each to profit from the transaction. One of the greatest difficulties such parties face in maximizing the joint surplus of the transaction is the severe asymmetric information problem between the seller and the buyer regarding the business to be transferred (the target). The market has developed two main tools to overcome this problem. First, before the parties enter into a definitive agreement regarding a transaction, the seller provides the buyer with tremendous amounts of non-public information about the target business (due diligence). Second, in the definitive agreement, the seller makes extensive representations and warranties about the target, thus assuming liability if these factual statements about the target turn out to be false.

With respect to rights and obligations arising from representations, however, the development of the common law at the intersection of contract and tort has made the situation more complicated. Although the law has usually allowed parties to contract around actions for contractual misrepresentation, the situation was different with respect to fraudulent misrepresentations for a long time. Under the theory that fraud vitiates everything, contractual provisions purporting to limit remedies for fraudulent misrepresentations, including even extra-contractual misrepresentations, were long held unenforceable on public policy grounds. More recently, however, leading commercial jurisdictions like Delaware and New York have allowed sophisticated parties to agree that the only actionable representations will be those included in the definitive agreement, including with respect to actions for fraudulent inducement. This is accomplished by means of so-called “non-reliance clauses,” in which a party promises or represents that it is not relying on any representations by the counterparty except for those included in the definitive agreement.

Even some sophisticated parties are surprised to discover, however, that representations made not actionable at common law by non-reliance clauses may be actionable under Rule 10b-5, the general antifraud provision of the federal securities laws. At issue is Section 29(a) of the Securities Exchange Act of 1934, which declares void any agreement “binding any person to waive compliance with any provision” of the act or rules promulgated thereunder. The United States Court of Appeals for the Second Circuit has held that non-reliance clauses, at least between sophisticated parties, survive under Section 29(a), but the First and Third Circuits have held otherwise and have allowed Rule 10b-5 suits based on extra-contractual representations to proceed.

After reviewing the common law background regarding non-reliance clauses, this Article provides an economic analysis of the process by which sophisticated parties to business combination transactions deal with the severe information problem inherent in such transactions, that is, the fact that the buyer comes to the transaction knowing relatively little about the target business, and certainly much less than the seller does. The process of dealing with this problem typically begins with the parties entering into a preliminary agreement, variously styled a confidentiality agreement or non-disclosure agreement, the primary purpose of which is to prevent the potential buyer from using confidential, non-public information about the target for any purpose other than evaluating a potential acquisition of the target. After such an agreement is signed, due diligence begins, and the seller gives the buyer access to large amounts of non-public information about the target business, including both written materials and information delivered orally in meetings and discussions between the agents of the parties.

In short, this Article argues that disclaimers, promissory non-reliance clauses, and representational non-reliance clauses are parts of an integrated system designed to produce an efficient set of representations and warranties as part of an efficient overall agreement between sophisticated parties. Since such parties come to the transaction wanting and expecting such a system, the clauses merely make express the understanding that participants in the market for corporate control already have. Even if such clauses were not included in the relevant agreements, the economic realities of the situation make it such that no reasonable seller would understand itself to making enforceable representations in due diligence, and no reasonable buyer would rely on any such representations. Even if enforceability were limited to fraudulent misrepresentations, the result would be a severely inefficient process that would decrease the value to the parties of the potential transaction.

Against this understanding of the economic realities of the dealmaking process, this Article then considers whether disclaimers and nonreliance clauses should be enforceable under Section 29(a). Arguing that Section 29(a) should be understood as preventing parties from tampering with the allocation of rights made by the federal securities laws, and relying on the economic analysis in the Article to show that no representations or warranties were ever made or received in due diligence and thus no rights created, the Article concludes that disclaimers and non-reliance clauses do not run afoul of Section 29(a). If the Supreme Court ever addresses the circuit split related to the enforceability of non-reliance clauses, it should adopt the view of the Second Circuit that such clauses are enforceable, at least as between sophisticated parties involved in business combination transactions.

Read the full article here.

Robert T. Miller, Rule 10b-5 and Business Combination Transactions, 21 U. Pa. J. Bus. L. 533 (2019).

For more publications by Professor Miller, visit his faculty bibliography page.