Corporate & Securities Law

More on "Strategic Sandbagging: Let the Buyer Beware"

By broc

More on "Strategic Sandbagging": Let the Buyer Beware

Reacting to this blog recently from John Jenkins, a member posed the question: why, given the virtually universal use of indemnification, does reliance matter? This member would characterize most claims as actions to enforce a covenant to indemnify for damages resulting from inaccuracies in representations and warranties, rather than claims for breaches of representations and warranties themselves - and he noted John's somewhat oblique reference to specific indemnities and wondered if he had given any thought to the issue.

The member stated there are three main fact patterns:

1. Traditional breach of representation or warranty claim that can be analyzed under the existing case law relating to the reliance element - Ziff Davis or Galli v. Metz, which are fact specific and can lead to different results

2. Specific/special indemnity - indemnification for any loss relating to a specific issue - e.g., environmental problem, cost overruns on budgeted severance

3. Traditional indemnity for breach or inaccuracy of representation

John Jenkins responsed to this question as follows:

I'm not sure I've got a good answer to your question, although I think there are two reasons that reliance still matters:

1. I think that because of the indemnity right's status as a remedy that is tied in some fashion to a "breach" (whether defined broadly to include inaccuracies or in more narrow terms) of a rep or warranty, courts that think reliance matters won't view the covenant to indemnify as being an independent obligation. The existence of a right to indemnity is predicated on the rep, and therefore reliance on the rep remains an issue when a claim for indemnity is made.

2. The more fundamental problem is that you get it right, and the courts that adopt a reliance requirement don't. You're applying contract law principles to contract law issues, while the courts that are requiring a showing of reliance in these cases aren't. They are importing the tort concept of reliance into contract claims, which doesn't make sense to begin with:

"Transplanting tort principles into contract law seems analytically unsound. If a party to a contract purchases a promise, he should not be denied damages for breach on the grounds that it was unwise or unreasonable for him to do so. Indeed, Judge Hand admonishes: 'To argue that the promisee is responsible for failing independently to confirm [the warranty], is utterly to misconceive its office.' Metropolitan Coal Co. v. Howard, 155 F.2d 780, 784 (2nd Cir.1946). Thus, a claim for relief in breach of warranty is complete upon proof of the warranty as part of a contract and proof of its breach." Ainger v. Michigan General Corp., 476 F.Supp. 1209, 1224-1225 (S.D.N.Y. 1979).

Once courts have crossed this particular Rubicon, it's probably not too surprising that they would go on to ignore other principles of contract law, like the one that prompted your concerns.

If you read Robert Quaintance's article (which is where the quote about specific indemnity rights came from), I think this is where some of his concerns are coming from. For example, he says that buyers that rely solely on express reservations of rights run the risk of running into a court that looks principally to Ziff-Davis, "where timing [of the buyer's knowledge] seemed to matter a lot - and reservation of rights seemed not to matter very much - and holds that that if the buyer knew before signing that the seller's representation was untrue, the buyer could not have been relying on that representation when it entered into the agreement." In other words, the risk is that a court might approach the contract issues from a tort law perspective that elevates the "reliance" concept above the ability of the parties to bargain their own appropriate allocation of risk.

Full post as published by DealLawyers.com Blog on June 24, 2009 (boomark / email).