Getting What You Bargained for: Avoiding Legal Uncertainty in Survival Clauses for a Seller’s Representations and Warranties in M&A Purchase Agreements
2019 I 12 J. Bus. Entrepreneurship & L. 1 I Will D. Pugh
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Introduction
After an entrepreneur invests hard work, time, and ingenuity in a business, she will sometimes decide to sell her business to someone else. Before that sale, she will know much more about the company than any prospective buyer. Consider, for example, her knowledge of the business’s conformity with tax law, her liability under contracts with suppliers, environmental regulatory risks, her financial statements’ GAAP compliance, and her authority to sell the company. One transaction cost of the sale is the time and effort that the buyer will spend learning about the business. The buyer and seller can allocate this cost between themselves with the use of representations, warranties, (“reps and warranties”) and contractual remedies for their breach. Through reps and warranties, the seller can disclose information that she knows about the business and answer the buyer’s specific questions. Reps and warranties are more efficient than requiring the buyer to conduct an exhaustive investigation of every aspect of the business because they allow a seller to use her knowledge about the company. Normally, when the seller uses reps and warranties, the she will promise to indemnify the buyer for any damages arising out of false reps and warranties. In a properly drafted agreement, the buyer only has a right to indemnity if the seller’s reps and warranties were untrue when they were made. A key topic of negotiation becomes how long the buyer will have to discover that one of the seller’s reps or warranties was false when made. In most agreements, this discovery period is referred to as the “survival” period.
For example, typical Merger and Acquisitions (“M&A”) agreement might state:
All representations and warranties contained in this agreement shall survive the closing for a period of eighteen (18) months after the closing date (the “Survival Period”). The Seller shall indemnify and hold Purchaser harmless from and against and agree promptly to defend Purchaser from any losses, damages, costs and expenses as a result of or in connection with any inaccuracy or breach of any of the express representations or warranties made by Seller in this agreement. [This indemnification provision] shall be the Purchaser’s sole and exclusive remedy for any inaccuracy, non-fulfillment or breach of the representations and warranties contained in this Agreement. Each party’s indemnification obligations shall terminate at the expiration of the applicable Survival Period, provided however, that the Survival Period shall not affect the parties’ rights and obligations with respect to any claim thereunder if written notice of a breach thereof is made in accordance with [the procedural notice provisions in the agreement].
To explain the mechanics of the provision above, first, a seller makes specific reps and warranties about the business. Next, the seller agrees to indemnify the buyer for any damages caused by an inaccuracy of the seller’s reps and warranties. Further, the Buyer agrees that he has no other legal recourse for an inaccurate rep or warranty other than his right to indemnification from the seller. In addition, the seller will want to get “off the hook” after some period of time. Therefore, both (i) the right to indemnity and (ii) the reps and warranties are said to “survive” closing—but only for a specific period. In the example above, that survival period is eighteen months. Lastly, the parties usually specify a notice procedure whereby the buyer agrees to notify the seller if he believes that he may have a claim to indemnification. This gives the seller a chance to fix the breached rep or warranty before a lawsuit is filed.
Provisions like the one above are very common. In M&A transactions, a seller will almost always make some reps and warranties to the buyer regarding the seller’s business. The seller is always in a better position to know about and quantify risks, so buyers usually require the seller to stand behind at least some baseline facts about the business before he pays the seller. In practice, the fulsomeness of the seller’s reps and warranties depends on the bargaining power of the two parties. If the seller has lots of bargaining power, she can make the transaction more like an “as is” or “quitclaim” deal. If the seller has little bargaining power, she will have to indemnify the buyer for many risks associated with operating the business.
In summary, reps, warranties, indemnification rights, and survival periods help the parties to pre-negotiate the seller’s post-closing liability for hard-to-quantify risks. Because indemnification is the buyer’s only remedy post-closing, when the right to indemnification cuts off, the seller knows that the proceeds she received in the sale are no longer at risk.
This “basket” of provisions (including reps, warranties, indemnification, and survival periods) could, at least hypothetically, intersect with some state’s statutory provisions called “controlling statutes.” Controlling statutes prohibit a contractual shortening of the otherwise-applicable statute of limitations. This note argues that statutes prohibiting sophisticated business people from bargaining for a survival period should be repealed. In Order of United Commercial Travelers of America v. Wolfe, the Supreme Court held that parties can contractually shorten an otherwise applicable statute of limitations. However, the Supreme Court left open the states’ ability to enact “controlling” statutes which explicitly ban contracts that shorten the applicable statute of limitations on public policy grounds.
This note argues that, while states may enact controlling statutes, they should not because such statutes (i) inefficiently limit the tools that parties have to allocate risk and (ii) create a lack of national uniformity. This note will show that there are nine states with laws that could invalidate important provisions in 94 percent of M&A agreements. These laws should be repealed. Secondarily, this note will seek to explain and clarify the complicated web of rules related to this topic. Part of this explanation will involve an argument that the contractual survival period is logically distinct from common law suits over breached reps and warranties. This distinction makes it inappropriate to argue that the statute of limitations can step in to step in to extend the time period that a buyer has to sue a seller beyond the survival period.
Imagine that the previously mentioned entrepreneur (Sally, for the sake of this example) has grown a small chain of gas stations in Alabama, and Sally now wants to retire to her family farm. Sally identifies an interested buyer, Bob. Bob is an aggressive bidder, but he is concerned about a potential Environmental Protection Agency (“EPA”) violation from gasoline runoff at one of the gas station properties. Sally does not think that the gasoline leak is a serious problem, but to assuage the Bob’s fears, she makes a specific representation that, as of the deal closing, there are no EPA violations on the gas stations’ property sufficient to have a material adverse effect on the company. Bob likes this idea because it acts as an insurance policy from Sally against the hard-to-quantify risk that the property is currently violating EPA regulations.
Sally, eager to sign a deal, decides to grant Bob a right of indemnification, and she gives Bob a choice. Bob can accept a two-year right of indemnification at his current bid price ($1,000,000), or he can get a three-year indemnification right by raising his bid to $1,100,000. This means that in the event that Bob can prove, within the survival period, that Sally’s EPA representation was false when it was made, then Sally has to compensate Bob for any damages he incurred in relying upon her representation. In other words, Sally might be paying the EPA to fix the problem. The period that Bob has to discover that a representation was false (when made) is the “survival” period.
Bob is satisfied, and he takes the two-year indemnification right because he thinks that if there is a problem, surely, he will be able to discover it in two years. The deal closes, and two years pass. During the third year, Bob is appalled when he gets notice from the EPA that one of the gas stations has been leaking fuel into a river for the past ten years. Bob decides to consult his attorney. Bob remembers that he only got an indemnification right for two years because he was not willing to pay the extra $100,000, so Bob fears that his attorney will say that he is out of luck.
Fortunately for Bob, his attorney just got back from his CLE credit where he saw a presentation about states, including Alabama, which statutorily prohibit contractual shortening of the applicable statute of limitations. The presentation warned practitioners that there are at least nine states (Alabama, Florida, Louisiana, Mississippi, Missouri, Montana, Oklahoma, South Carolina, and South Dakota) that have “controlling statutes” prohibiting “contractual shortening” of the statute of limitations. Thus, Bob’s lawyer advises Bob to sue Sally three-years after closing even though Bob did not pay the extra $100,000. The attorney advises Bob to argue that Alabama’s six-year statute of limitations for actions upon a contract is the actual time period that Bob had to discover that Sally’s representation was false. Bob’s lawyer advises him to make this argument notwithstanding that Bob and Sally specifically bargained over the survival period.
Buyer-Bob’s argument is the exact argument that was made in Pinnacle Great Plains Operating Co. v. Wynn Dewsnup (“Dewsnup”) which involved the sale of 5,487 acres of land in Idaho (the “Property”) for $15,300,000 by means of a Real Estate Purchase Agreement (“PSA”). Dewsnup turned, in large part, on Idaho’s controlling statute, Idaho Code § 29-110, which states, “Every stipulation or condition in a contract, by which any party thereto is restricted from enforcing his rights under the contract in Idaho tribunals, or which limits the time within which he may thus enforce his rights, is void as against the public policy of Idaho.” (the “Idaho Controlling Statute”).
In Dewsnup, the buyer discovered, post-closing, that sodium levels on the Property were too high to be used for irrigation—a fact which “preclude[ed] normal agricultural activities on the property.” The utility of the property for agricultural purposes was expressly addressed in the PSA because the seller represented that the Property “has access to water resources necessary in the operation of agricultural activities” (the “Water Rep”).
The PSA also provided that the Water Rep “shall survive the Closing…of this Agreement for a period of one (1) year.” The buyer was able to discover the elevated sodium levels and notify the seller that the Water Rep had been breached before the one-year survival period ended, but the buyer did not file suit within the one-year period. When the buyer filed suit, the seller argued, inter alia, that (i) notice of the breached Water Rep was insufficient and that the seller had to actually file suit before the survival period ended and (ii) the Idaho Controlling Statute barred any contractual limitations period shorter than five years. Specifically, according to the buyer, Idaho’s statute of limitations for breach of contract was five years, and thus, the PSA’s survival period of one year was void because it violated the Idaho Controlling Statute since the PSA purported to “limi[t] the time within which [the buyer] may thus enforce his rights.”
The court began its analysis by noting that “Idaho has expressed a fundamental policy by requiring strict adherence to its statutory limitations period.” The court went on to hold, for reasons discussed in Section II.C, that the PSA did not require the buyer to file suit within one year. However, before reaching this holding, the court wrote in dicta that “a one-year limitation on [the buyer’s] lawsuit is tantamount to [a void agreement] under Idaho law.” Therefore, it appears that, at least under Idaho law (and potentially the law of any other state with a similar controlling statute) parties cannot set survival periods of less than the otherwise applicable statute of limitations.
This note will examine the variables that effect the way that courts may limit parties’ contractual freedom to shorten or lengthen statutes of limitation. It will describe the legal levers that determine the applicable survival period and suggest ways that parties can reduce legal uncertainty around the “basket” of provisions including reps, warranties, survival, and indemnification periods. One key detail examined by this note is borrowing statutes that could operate to “import” another state’s controlling statute. Additionally, this note will discuss ways in which the contractual right to indemnification for breached reps and warranties is a substantive right that is inextricably tied up with the duration of the right in such a way that statutes of limitation are not even implicated. Specifically, this note will argue that a contractual indemnification and the concomitant survival period is distinct from the common law right to sue for misrepresentation. This distinction makes it illogical for courts to invalidate bargained-for survival periods on the grounds that they violate the statute of limitations.
I. Background
In the modern M&A context, every transaction involving the sale of a company will be governed by some form of a Purchase and Sale Agreement. One of the perennial, and highly negotiated, sections of this agreement is the reps and warranties section where the seller describes what she is selling. The scope and detail of the seller’s representations in the agreement will vary based upon the seller’s relative bargaining position with a more powerful seller able to make very few representations about her business—thus shifting due diligence costs to the buyer. Therefore, when a high-powered seller (who makes few reps and warranties) sells a company, it is more of a “caveat emptor” transaction. The seller wants to limit reps and warranties because each rep or warranty about the company is an opportunity for the buyer to push risks back to the seller if a latent defect is discovered post-closing.
With this buyer-seller tradeoff in mind, the reps and warranties section has four main business purposes: (i) for the seller to consolidate and disclose known information relevant to the buyer’s decision to purchase the company, (ii) to allocate risk between the parties pertaining to negative facts that may not be known to either party at the time of sale, (iii) to provide the buyer with a “walk right” or ability to not purchase the company if the buyer discovers, before closing, that the seller breached a rep or warranty, and (iv)—in tandem with the indemnification and survival provisions—to allow the seller to define her post-closing risk by defining the buyer’s only legal remedies if any of the reps and warranties turn out to have been breached (i.e., false) as of the time of closing. While all goals are relevant to this note, the second and the fourth goals, to allocate risks pertaining to unknown facts and to allow the seller to define her post-closing risk, are the most important.
For U.S. transactions in 2015, 82% of Purchase and Sale Agreements provided that the buyer’s right to indemnification for breached reps and warranties would survive for at least 18 months after closing. Depending on the parties relative bargaining power, the survival period could terminate immediately post-closing or extend past five years in some contracts especially in dealing with so-called “fundamental” representations and warranties. The graph located here shows a more detailed look at the survival periods for non-fundamental reps and warranties for deals that closed in 2012.
Some reps and warranties are “fundamental” and have a longer survival periods of three to five years—depending on negotiation. Some common examples of “fundamental” reps and warranties include: the seller’s organization and standing, the proper payment of brokers and finders fees, title to assets or securities, tax liability, and GAAP compliance of financial statements. The chart located here shows the percentage of deals that “carved out” specific reps and warranties (to become “fundamental” reps and warranties). Frequently, these reps and warranties are subject to a longer survival period because they are more important to the buyer.
These two graphs are important because, as this note will show, controlling statutes threaten to invalidate a large percentage of survival clauses. Controlling statutes prohibiting contractual shortening of the statute of limitations are currently enacted in Alabama, Florida, Louisiana, Mississippi, Missouri, Montana, Oklahoma, South Carolina, Idaho and South Dakota. 37 Based off of the data above and cases like Dewsnup (mentioned in the Introduction to this note), these statutes could invalidate at least 94 percent of all survival clauses in M&A agreements. Fundamental reps and warranties that survive longer are at an even greater risk. It is unclear how aware practitioners in the M&A space are of the interaction between survival periods and controlling statutes.
To further-complicate the issue, this note will show that it is the state where a Purchase Agreement arises that will determine the source of law for procedural matters. Therefore, parties cannot simply contract around a controlling statute by providing that the agreement will be governed by the law of another state. Part of this note’s intention is to increase awareness of the general operation of the statute of limitations rules and to give practitioners some tips on how to avoid unexpected consequences.
One of the most important state laws related to this topic is Delaware because of its centrality to M&A deals. In 2014, Delaware amended its statute of limitation to expressly allow parties to set contractual statutes of limitation for agreements involving at least $100,000 as long as the time period set by the agreement is less than a twenty-year maximum. This would seem to eliminate any doubt that a survival period of zero to 20 years is valid. Unfortunately, other states have not been so quick to explicitly accommodate bargained-for risk allocation choices and may, in fact, statutorily prohibit contractual shortening of the “applicable” statute of limitation. This means that, for example, a court applying the South Carolina Statute of Limitations for action upon a contract (3 years) could arguably invalidate the vast majority of contractual survival clauses (usually less than two years).
To further illustrate why survival clauses are at risk, note that South Carolina prohibits contractual shortening of the limitations period. However, most agreements provide that the right to indemnity for breached reps and warranties survives for only eighteen months. Therefore, because eighteen months is shorter than three years, most survival periods ostensibly “bar[s] [a party] from bringing suit upon any cause of action arising out of the contract if not brought within a period less than the time prescribed by the statute of limitations.”
While the parties to a Purchase and Sale agreement will remain free to simply select Delaware law to substantively govern their agreement, it may be the forum selection clause46 which actually determines the applicable statute of limitations because the statute of limitations is a procedural law for purposes of the Erie doctrine—at least in Delaware. This note will explain the risk that—if the parties are either (a) litigating in a forum that prohibits a contractual modification of the statute of limitations or (b) litigating in Delaware, but the case “arose” in a forum that prohibits contractual modification—the parties’ attempt to contractually modify the statute of limitations with the use of a survival clause could be void.
To explain this risk, it is important to understand the Delaware Statute of Limitation with an eye towards (i) the operation of Delaware procedural law and (ii) the operation of key contractual clauses related to the survival period.
II. Analysis
A. Operation of the Delaware Statute
The Delaware statute of limitations, as amended in 2014, sets a three-year statute of limitations, but if the agreement involves at least $100,000, then it may be brought as “specified” in the written contract—up to a maximum limit of 20 years. This statute has been described by courts as setting a “contractarian” statute of limitations, but there are still some unclear—or at least confusing—areas of the law. Specifically, what will determine the source of law for the limitations period, what language must the parties use to specify the limitation period, when does the limitation period begin to run, what must plaintiff do to satisfy the limitation period, what effect does a notice requirement have on the limitations period, what effect do choice of law provisions have, and can contractually lengthen the statute of limitations? Because they are important to explain ways to reduce risk in this area of law, these topics will be addressed in turn before moving to contractual, legislative, and judicial suggestions.
B. Determining the Applicable Limitations Period
The traditional rule, adopted by Delaware, treats the statute of limitations as a procedural law. Thus, it is the forum selection clause and not the choice of law provision that will determine whether the Delaware contractual statute of limitations will apply. This procedural / substantive distinction can be overlooked which could have expensive consequences if an agreement’s forum selection clause chose a jurisdiction that did not respect bargained-for limitations periods. One might think that selecting Delaware in the forum selection clause would guarantee that a court would apply the Delaware “contractarian” statute of limitations. Unfortunately, even if both the forum selection clause and the choice of law provision select Delaware law, the purchase agreement might still be limited by another jurisdiction’s “controlling statute”—at least if the agreement arose outside of Delaware.
This additional wrinkle comes from Delaware’s “borrowing statute” which requires that, if a cause of action “arises” outside of Delaware, courts must use the shorter of: (i) the statute of limitations in the jurisdiction where the cause of action arose or (ii) the Delaware statute of limitations. Thus, even if a party is litigating in Delaware, the Delaware procedural law may be forced to adopt or borrow another state’s procedural law if the claim arose in a state other than Delaware.
The flow chart here shows the potential interaction of forum selection and the “borrowing” statute—at least under the plain language of the borrowing statute. Borrowing statutes give rise to two distinct implications. First, the forum court’s procedural law will apply. This means that the forum court’s stance towards shortening or lengthening the statute of limitations is the relevant source of law—potentially including any “controlling” statute that limits parties’ ability to shorten the statute. Second, at least in Delaware, the borrowing statute may require that a different forum’s statute of limitation govern.
To further complicate the matter, Delaware courts have not always constructed the borrowing statute according to its ordinary meaning. Some Delaware courts have applied a purposivist reading to the borrowing statute. These purposivist readings refuse to “borrow” another jurisdiction’s statute of limitations unless there is evidence that a plaintiff chose to sue in Delaware in order to take advantage of Delaware’s longer statute of limitations. However, this purposivist construction of a statute may not be relevant where the parties have used a forum selection clause because, presumably, it is not possible to forum shop by selecting a contractually mandated forum. The plaintiff is simply not seeking a litigation advantage by suing in Delaware where a contract mandates that he sue in Delaware. The plaintiff has no choice. To the extent that a court uses a purposivist construction of the borrowing statute, another jurisdiction’s statute of limitations will not be imported and the Delaware “contractarian” rule will apply.
However, it appears that the majority rule in Delaware is to apply the borrowing statute according to its plain meaning without examining the purposes behind the statute. If courts use this literal construction, then the Delaware borrowing statute could very well “borrow” another state’s shorter statute of limitation.
Thus, it remains theoretically possible for parties to sue in Delaware court, but have the dispute “arise” in another state which statutorily limits the parties’ ability to contractually shorten the statute of limitations (such as South Carolina, Alabama, Florida, and Missouri). In such a case, a Delaware court might also “borrow” or adopt that other state’s limitation on the parties’ ability to contractually shorten the limitations period notwithstanding Delaware’s normally permissive statute of limitations. In such an event, Delaware is, in a sense, adopting the other jurisdiction’s statute for purposes of the dispute at issue. This point will become important later in the note when discussing whether the borrowing statute would mandate a temporary enactment of another jurisdiction’s controlling statute as an “accoutrement.” This topic will be discussed along with the importance of repealing—or modifying—borrowing statutes.
C. Contractually “Specifying” the Limitations Period
Another potential area for confusion arises because: while some jurisdictions require “clear and explicit” language to shorten the statute of limitations, Delaware does not require any specific language other than simply providing that reps and warranties will “terminate” after a specified period. However, in some “clear statement” jurisdictions, in order to shorten the statute of limitations, one must both (i) provide a clear statement that the representations and warranties will only “survive” up to a specific date and (ii) provide that any action, lawsuit, or demand must be filed before—a specific period. In other words, the contract must both state that the survival period is X years, and after X years, no party can sue.
Clear statement jurisdictions will distinguish between (i) the period within which a breach must be discovered and (ii) a clause that explicitly cuts off a right to sue for the underlying representation. These jurisdictions impose this type of clear statement rule to pursuant to the public policy of not favoring contract clauses that “limit the right to sue to a period shorter than that granted by statute.” Delaware, to the contrary, will construe a limitation on an indemnification right as a contractual statute of limitations.
For example, Delaware courts have held that the following language unambiguously shortened the applicable statute of limitations: “the representations and warranties of the Seller (…) shall survive until the second anniversary of the closing date”. Contrast this language with jurisdictions that require a “clear statements” to shorten a limitations period. Consider California and Idaho. Courts in both of these jurisdictions have held that agreements stating that representations “shall survive…for a period of one year” do not cut off the time within which a party could file suit.68 Instead, that language only “specif[ies] when a breach of the representations and warranties may occur.”
D. The Start of the Limitations Period
Generally speaking, representations and warranties in a purchase agreement are either true or false when they are made, and the plaintiff can commence legal action immediately. Thus, claims by a plaintiff seeking indemnification for a breached representation accrue at closing, and the statute of limitations begins running at that same date whether or not the purchaser had actual knowledge of the breach.
Note that accrual is another area where clarity is important. Courts usually hold that claims for indemnification based off of breached reps and warranties accrue at closing. However, closing-accrual may not occur for a stand-alone indemnification right that is specifically related to other kinds of claims (i.e., indemnification rights not tied to reps and warranties). In other words, the agreement could grant the buyer a stand-alone right to be indemnified for any future environmental costs associated with the intentional bad-acts of the seller. Presumably, this type of claim would accrue when the cost was incurred and not at closing because it is a more traditional indemnification right. This type of right, in effect, would make the seller an insurer for the purchaser in a way that was unrelated to any reps or warranties.
E. Requiring Notice of a Suspected Breach of Reps and Warranties
Normally, as discussed, a plaintiff must actually file suit to satisfy the statute of limitations. There is one notable exception to this rule. The parties can use a notice provision to require the buyer to notify the seller in the event that one of the reps and warranties turns out to be defective. This notice can “toll” (pause) the statute of limitations. In other words, if the agreement is properly written, a buyer need not actually file a lawsuit within the survival period in order to satisfy the statute of limitations. Instead, he might simply give proper contractual notice to the seller of a suspected defect which will give more time to resolve the issue while still preserving the buyer’s ultimate recourse of filing suit. A key issue in these cases becomes (i) what is the trigger for the toll and (ii) what is the duration of the toll? Contracts should carefully define both.
For example, in Friedman Fleisher & Lowe v. AccentCare, the Delaware Court of Chancery held that a buyer’s suit was foreclosed when a buyer filed suit after of the survival period because—even though the buyer gave “notice” of his claim to the seller before the survival period had run—the agreement did not explicitly provide that such notice would extend the survival period. In short, the court adopted a rule that: unless a notice provision explicitly extends the time period for filing a suit, the survival period is not extended by notice. The notice provision is reduced to a courtesy that the buyer must give to the seller before filing suit which has no impact on the underlying survival period. The notice is merely a procedural condition precedent to filing suit. Therefore, agreements should be clear about whether the notice is simply a procedural condition precedent to filing suit or both a condition precedent and a mechanism to toll the contractual indemnity period (within which suit must be filed).
F. Choice of Law Provisions
The traditional Erie doctrine would require the application of a forum’s statute of limitations. However, some jurisdictions—not including Delaware—have held that a choice of law provision (e.g., “this agreement should be governed by Florida law”) requires the application of [Florida’s] statute of limitations instead of the forum’s statute of limitations. This is a shift from the traditional rule that statutes of limitation are procedural and should be supplied by the forum. Instead, this alternative view is that statutes of limitation are substantive—at least in the face of a contractual choice of law provision in the M&A context.
Alternatively, as a third option, if a forum selection clause singles out a specific state’s statute of limitations to govern the agreement (e.g., “Delaware law, including its statute of limitation, shall govern this agreement”), it is likely that a Delaware courts, with their tendency to honor bargained-for agreements, would give effect to that bargain. Some jurisdictions have adopted this position and allow parties to specifically select a forum’s statute of limitation if they do so explicitly. Note however that in these “specific selection” states, courts refuse to abandon the traditional rule that statutes of limitation are procedural and governed by the law of the forum absent explicit language in the agreement.
G. Lengthening of the Statute of Limitations
Delaware’s statute of limitations prohibits parties from contractually lengthening the statute of limitations past twenty years. This prohibition is based off of evidentiary policy decisions to “preven[t] allegedly-breaching parties from being unfairly made to address stale claims for which proof becomes progressively less trustworthy over time.” Thus, while Delaware is willing to adopt a contractarian stance towards shortening the statute of limitations, it is unwilling to afford parties similar latitude to lengthen the period (at least beyond twenty years).
Other jurisdictions have similar policy positions to the effect that contracts which lengthen the applicable statute of limitations are void as against public policy. However, as noted above, it may be possible for the seller to grant the purchaser an independent indemnification right that is unrelated to any representation or warranty—such that the claim did not accrue until the buyer made a demand on the seller. This would, in effect, make the seller an insurer for the purchaser.
H. Summary of Current Law
In summary, there are jurisdictional differences when it comes to whether statutes of limitation are substantive or procedural, what level of specificity is required to contractually set the limitations period, and whether states permit any contractual modification of the statute of limitations. While current law creates a bit of a maze for parties to get what they bargained for, there are ways to simplify this area of law.
III. Solution
In determining how a court will enforce a survival clause, there are three main variables: The forum selection clause, the choice of law provision, and the way that the contract words its indemnification and survival clauses.
First, the forum selection clause will, at least under the traditional rule, determine the procedural law that governs the agreement. Second, the choice of law provision will select the substantive law to govern the agreement, and third, the contract itself is an important source of law. This note assumes that the “correct” legal outcome is for courts to require a plaintiff to bring suit within the survival period.
The main threats to the “correct” outcomes are, as previously mentioned, that (i) a forum state will use its borrowing statute to “borrow” another state’s statute of limitation which could include a controlling statute, and (ii) that a forum with a controlling statute will disregard a choice of law provision in a contract and substitute its own procedural law. Either of these two outcomes could throw off the parties bargained for agreement.
A. Contractual Solutions
There are two main strategies that parties can adopt to reduce the aforementioned risks: (i) carefully worded choice of law provisions and (ii) liability limitations clauses. First, in jurisdictions that prohibit contractual shortening of the applicable statute of limitations, the parties may be able to contract around the default rule that statutes of limitation are procedural (i.e., supplied by the law of the forum) by emphasizing the centrality and substantive nature of the survival period. This approach was explained in Section II.F which details how some agreements may be able to turn procedural rules into substantive rules by emphasizing their centrality to agreements.
In other words, the parties may be able to specify that that the duration of the indemnification right is substantive for the purposes of their agreement. Whether the parties are able to achieve this procedural–substantive shift will turn on the forum’s law on the conflict of laws. While a complete fifty-state survey is beyond the purview of this note, a strong case can be made that—at least for shortening the statute of limitations—parties should be able to contract around the traditional rule that statutes of limitation are procedural.
The traditional distinction between substantive and procedural rights is that a statute of limitation “does not wipe out the substantive right; it merely suspends the remedy.” In other words, while a party may have a substantive right to indemnification under an agreement, the courts of the forum jurisdiction will not provide a remedy for the breach of that right after a specific time period.
Contrarily, in an agreement that creates a right to indemnification, but only for a limited time period, it is most precise to say that the contract granted a substantive right with a temporal component.
A buyer should not be able to legally vindicate a substantive right that the seller did not give. As has been shown in this note, the survival period is one of the most negotiated terms in an M&A agreement. A right to indemnification for defective reps and warranties that lasts six months could be worth millions less than a similar right that lasts five years. Thus, while the traditional rule is that statutes of limitation pertain to the availability of a remedy, a limited survival period is—by its nature—substantive in the minds of the parties.
Further, courts sometimes refer to the statute of limitation as expressing the legislature’s policy judgment regarding the use of judicial resources and the litigation of stale claims for which evidence is scant. This rational is inapplicable to a contractual shortening of the limitations period between sophisticated parties who specifically addressed the issue, and it should, in fact, help to preserve judicial resources.
Other courts, as exhibited in the Dewsnup case, rely on an amorphous “fundamental policy [of] requiring strict adherence to… statutory limitations period[s].” It is unclear what the motivating principle behind this fundamental policy is. If legislatures are concerned about asymmetric bargaining power and draconian limitations periods, then they could follow the Delaware legislature which only grants flexibility to parties negotiating contracts valued at over $100,000.
The most important point to remember is that: to the extent that “substantive” rights turn on the intent of the contracting parties, if courts were to substitute a different limitation period than the survival period in the contract, they would be giving a substantive right to the buyer that the seller did not grant. Under every meaning of the word, the length of the survival period is substantive to an M&A agreement. This would be even more true where the contract explicitly mentioned the statute of limitations in its choice of law provision because it shows that the parties intention was for courts to respect their bargained for limitation. Thus, courts should adopt a rule— as California has—that an “agreement’s unqualified reference to the ‘laws’ of [a state in the choice of law provision] referred to all of that jurisdiction’s statutory laws, including its statutes of limitation.” This will, in turn, allow parties to select a forum with a “contractarian” statute of limitation.
However, this is only a partial solution, because there is still a risk that a “contractarian” state will also have a borrowing statute. For example, even if the parties select Delaware law, Delaware law might borrow from a state where the contract arose which could include a controlling statute.101 Thus, at least when parties’ agreement “arises” in a jurisdiction with a controlling statute, the parties may be limited in their ability to contract around that limitation.
For parties in these situations, they might consider a liability limitation provision. Such a provision would state that: for lawsuits filed after [eighteen months] from the closing date, the buyer’s sole remedy for breaches of the seller’s representations and warranties shall be a suit for indemnification, and damages for such a breach shall be capped at [a very low number]. This would not prevent the parties from filing suit, but it would achieve the goal of shifting risk to the buyer after some time period. For the enforceability of such a liability limitation, see the following footnote.
B. Legislative Solutions
While Delaware has taken significant steps to increase the freedom of contract regarding limitations periods, Delaware and other states should take additional steps to statutorily enable contracts with a value of over $100,000 to contractually specify how they want their agreement to behave in court. Specifically, States should both (i) amend their borrowing statutes to specify that nothing should limit parties ability to provide a limitations period that is less than 20 years, and (ii) amend their choice of law statutes, similar to Del. Code §2708, to specifically allow parties to a contract involving more than $100,000 to agree that their undertaking shall be governed under the laws of their state, including their statute of limitation. Both of these changes, taken together, would increase parties’ ability to select “contractarian” law and reduce the risk that another state’s prohibition on contractual shortening would constrain the freedom of contract.
- Borrowing Statutes and Accoutrements
The first group of amendments, to borrowing statutes such as Del. Code § 8121, would eliminate the threat that the forum state would “borrow” another state’s prohibition on contractual shortening or lengthening where a dispute arose in another jurisdiction. Current law is unclear whether a Delaware court would borrow another state’s statutory prohibition on contractual shortening or lengthening as an “accoutrement” to the statute of limitations. A federal district court, applying Delaware law as quoted from the Delaware supreme court, wrote that § 8121 required a Delaware court to apply “another jurisdiction’s statute of limitations . . . with all its accoutrements; include[ing]… rules governing time when causes of action accrue.” Thus, it is unclear whether a defendant-seller who had selected Delaware law to govern her agreement and who was in court in Delaware would be able to win on a statute of limitations defense if her lawsuit arose in South Carolina. This is true even though she signed an agreement that would otherwise have limited a buyer-plaintiff’s right to sue for indemnification.
For example, the logic of the Delaware statute for contractual shortening, under its plain meaning, would be as follows: If the agreement limited the buyer’s right to sue to one year after closing and arose in South Carolina, then the court would apply the “shorter” of “the time limited by the law of [South Carolina]" or the time limited by Delaware Law. This would mean comparing the shorter contractual limitations period and the longer, three-year period of limitations under South Carolina law. Thus, under its plain meaning, the borrowing statute would select the contractual limitations period instead of the statutory period in South Carolina.
However, cases that speak of the Delaware borrowing statute as borrowing “accoutrements” could create uncertainty in this area because a plaintiff could argue that the Delaware court should adopt another state’s policy determination on limiting limitations periods as a procedural “accoutrement” to the limitations period. Additionally, other states with borrowing statutes have rules that more generally borrow another statute of limitation. In other words, by the terms of the borrowing statute, courts should not only borrow the limitations period but also apply the limitations period as the other jurisdiction would. For example, Alabama’s borrowing statute applies the other jurisdiction’s statute of limitations “in the same manner it would have been in the state or country where the… contract [was] made.” This type of borrowing statute would be much more likely to “borrow” a controlling statute.
Alternatively, contractual lengthening of the limitations period is seriously jeopardized by the borrowing statute. When examining a survival period that lengthens the statute of limitations, a Delaware court would compare another jurisdiction’s statute of limitation with the twenty-year contractual limitations period in Delaware. The borrowing statute instructs the court to apply the “shorter” of the two statutes. This comparison could cut off a buyer’s right to indemnification sooner than the parties bargained for if another jurisdiction’s statutory or common law prohibition on lengthening. - Controlling Statutes
States should repeal controlling statutes, at least for contracts with a value of over 100,000 because the traditional rational for strict enforcement of statutes of limitation is inapplicable to survival periods in M&A transactions. Further, regarding contractual lengthening, as has been previously stated, statutes of limitation embody the legislature’s policy judgment that after a certain period of time, the courts should not hear stale claims because they both waste the judiciary’s resources and are particularly susceptible to falsification to the detriment of defendants.
First, regarding contractual lengthening, it probably is a good idea to prevent a buyer from suing a seller for a breached representation that is discovered two-hundred years post-closing. However, some states have relatively short statutes of limitation for claims based upon contract, but, with the addition of a simple “sealed” document, allow claims to be brought after a much longer period. It seems extremely formalistic to allow parties to bring a suit up to seventeen additional years later simply by calling a signature “sealed.” Further, it presents a rather easy-to-circumvent attempt to conserve judicial recourses. Therefore, at least to the extent that a state is willing to allow suit based off of a “sealed” document, it seems even-handed to allow parties to a high-dollar-value transaction to contractually specify the limitations period (at least up to what they could have achieved under seal).
Similarly, states with controlling statutes should feel no need to protect a sophisticated parties who bargain for a shorter survival period (and who shift purchase prices in light of the bargain). This note is not dealing with a situation where the seller engages in either fraud or duress to extract a shorter limitations period, but with a situation where a seller agrees to accept a specific price and one of the reasons for such acceptance has to do with her share of the risk. In the modern M&A context, broad provisions that prohibit parties from contractually limiting a buyer’s right to sue would only have the effect of giving such buyer a windfall.
A good example of a statute that still prevents contractual shortening as a default rule, yet carves out an exception for contractual shortening in sophisticated business transactions comes from Texas:
“[A] person may not enter a[n] . . . agreement that purports to limit the time in which to bring suit on the . . . agreement to a period shorter than two years. A[n] . . . agreement that establishes a limitations period that is shorter than two years is void in this state. This section does not apply to a[n] . . . agreement relating to the sale or purchase of a business entity if a party to the . . . agreement pays or receives or is obligated to pay or entitled to receive . . . value of not less than $500,000.
This language will have the effect of increasing freedom of contract in the M&A context by allowing parties to use the survival period as a bargaining chip rather than being limited to the default state statute of limitations.
In summary, states should follow Delaware’s lead and repeal controlling statutes and go a step further of resolving any ambiguity about shortening or lengthening (for contracts above a specified dollar amount).
C. Judicial/litigation Solutions under Current Law
Notwithstanding all of the previous discussion in this note, it may be possible to help parties get what they bargain for even if legislatures fail to act. It may be possible to distinguish between the contractual right to indemnification and the common law right to sue for breached reps and warranties. To explain this point, consider the following hypothetical.
Consider, again, the facts of Dewsnup: the case is for breach of a seller’s reps and warranties, the case is procedurally governed by the law of a state with a controlling statute, the defendant sought summary judgment based off of a contractual survival period that was shorter than the statute of limitations, but the statutory limitations period had not yet expired. As this Note has explained, the buyer may be able to argue that the contractual survival period is void based upon the controlling statute. However, the Seller could make the argument explained below.
The argument that the contractual survival period does not violate controlling statutes is that the contractual right to indemnity is a distinct type of substantive right that is inextricably tied up with duration. There does not appear to be a specific case where this line of argument was followed, but the interaction between the statute of limitations and survival clauses is not well-explored in the first place, so there is room for creative argument in this area.
To understand this argument, the first key point is that, by default rule, reps and warranties do not survive closing. Therefore, one would not naturally say that survival periods cut off of the remedy for a substantive right upon expiration. Instead, survival periods actually create the buyer’s substantive right to rely upon the seller’s reps and warranties. Delaware law is clear that a party can disclaim all reps and warranties. Such a disclaimer (frequently called a “non-reliance provision”) effectively leaves the buyer without the substantive legal right to rely upon the veracity—or the mere existence of—the defendant seller’s statements about the company. If a seller can totally eliminate a buyer’s post-closing right to sue for breached reps and warranties or even disclaim them altogether, she should be able to create a limited substantive right to rely upon her statements. The very nature of a procedural rule (such as a statute of limitation) is that it “does not wipe out [or create] the substantive right; it merely suspends the remedy.” It seems illogical to have a default rule that reps and warranties do not survive closing but to require them to survive up to the statute of limitations if the default rule is not used. This sort of all or nothing approach seems like a pointless abrogation of the freedom of contract.
The substantive right to rely on a seller’s statements of fact was originally the creation of common law. The historical rule, caveat emptor, put all risks on the buyer. However, courts decided that a seller could not haphazardly offer affirmative statements about the subject of the contract without some expectation that the seller would rely on those statements. Presumably, this common law right was limited by a statute of repose to prevent a buyer from sleeping on those rights. Note specifically that the statute of repose arose to cut off a substantive right that the parties did not explicitly create. Instead, the statute of repose was a judicial or legislative protection for sellers that was needed because courts created the open-ended common law right for a buyer to rely upon the seller’s representations.
Contracts evolved and parties began explicitly listing their reps and warranties while disclaiming all others. Respect for the freedom of contract allowed buyers to contractually wave any such substantive right to reliance where it is clear that parties intended to do so. Further, instead of leaving it up to the common law substantive right to rely on the seller’s reps and warranties, the parties contractually erased that right and replaced it with indemnification as the buyer’s sole remedy. It follows that, if the seller is capable of selling without granting any right to sue over breached reps and warranties, she should be able to grant a limited right to sue and that the duration of such substantive right should be determined by the contract and not by the external statute of limitations.
To summarize, where parties specifically address the buyer’s right to rely on the seller’s reps and warranties (including the duration of said right) within the four corners of the purchase agreement, that right to rely should be substantively linked to the survival period. Contractual survival periods of indemnity rights should be thought of as representing a distinct type of substantive right-to-rely that is inextricably tied up in the duration of the right.
Perhaps the best illustration of the substantive nature of the survival period is rep and warranty insurance. Modern insurance products offer the opportunity for a buyer and seller to purchase insurance which will cover any breaches of a seller’s reps and warranties if they are discovered and proven by the buyer within the survival period. Thus, for the payment of a specific premium, the insurance company will grant a contractual right. This right is functionally equivalent with the seller’s grant of indemnification rights that survive for a specific period, yet it is unquestioned that it is the terms of the contract and not the statute of limitations which “cut off” a buyer’s right to seek compensation from the insurance company.
Survival periods and insurance contracts function very similarly. In fact, survival periods are a subspecies of insurance product. Both parties to an insurance contract recognize an underlying risk and they place opposite “bets” related to the risk. In many cases, the risk relates to the occurrence or non-occurrence of an event.
One significant factor related to the value of each bet is the time period within which each party bets that the event will or will not occur. The price to ensure a building for all flood damages for 99 years is significantly more than the price to ensure a building for 1 year. Each of the two bets (the 99 year and the 1 year) are different risk-products. Similarly, when a seller sells a business and grants an 18-month survival period, she is selling a specific risk-product. This risk-product is a substantive right that should have nothing to do with the statute of limitations because the duration of the right is also the substance of the right.
In summary, because the source of law for the buyer’s right stems not from the common law but from the language of the contract itself which also specifically lists how long such a right will last, courts should not allow the statute of limitations to modify a substantive right-to-rely. Instead, courts should think of indemnification rights and specific survival periods as the contractual creation of a substantive right which is tied up with a specific duration.
Conclusion
When a buyer and a seller negotiate key provisions in an M&A agreement related to reps and warranties, controlling statutes may threaten the carefully-balanced allocation of risk between the buyer and seller. This risk must be analyzed in light of various states’ laws on whether the statute of limitations is a substantive or procedural law for purposes of the Erie doctrine. Also, the language the parties use to specify the survival period, whether a state has a borrowing statute, and whether a choice of law provision can select another state’s procedural law are all legal “levers” that can vary from jurisdiction to jurisdiction. Each of these levers should be closely analyzed by those drafting M&A agreements.
Solutions to reduce this risk include creative drafting of liability limitations, choice of law provisions, legislative amendments to borrowing statutes, and the repeal of controlling statutes. Perhaps the most innovative way to reduce risk in this area of law is to realize the distinction between the common law right to sue for breaches of reps and warranties and the contractual right to indemnity in a modern M&A agreement.
In the common law scenario, courts would allow a buyer to sue a seller when the seller went out of her way to state facts on which the buyer relied during the course of the transaction. The courts thus created an open-ended substantive right for buyers to rely upon sellers’ reps and warranties without any internal limits. Instead, the buyer’s right had to be externally limited by statutes of limitation and repose.
Contrarily, the modern M&A right to indemnification is internally limited in such a way that it is inextricably tied up with the duration of the survival period. If courts adopted this distinction between the contractual and common law right of reliance, much of the previously-mentioned complexity would fade because the right to indemnification would be a substantive right for which the forum’s procedural laws would be irrelevant.
