Private equity seller held responsible for fraud committed by CFO of portfolio company in M&A case

In a recent M&A case, the Netherlands Commercial Court (NCC) made a significant ruling that a seller was responsible for warranty breaches due to fraud committed by its portfolio company’s CFO, despite liability limitation provisions set in the purchase agreement.

The purchase agreement between the seller and the buyer included clauses limiting liability, stating that the buyer’s only recourse for breaches of warranties was through warranty and indemnity insurance, except in cases of fraud by the seller. The central question before the NCC was whether the fraud committed by the CFO could be attributed to the seller.

The Dutch Supreme Court’s doctrine on attributing actions and knowledge to legal entities guided the court’s decision. According to this doctrine, a manager’s actions and knowledge can be attributed to the legal entity if community standards deem them as such. Factors like the duty to communicate actions or knowledge and the duty to inquire for the entity play a role in this determination.

In this case, the NCC concluded that the CFO’s actions and knowledge were attributable to the seller because the seller was the parent company of the group involved in the M&A and the CFO was aware of the transaction. Although the SPA defined “knowledge of the seller” to include the CFO’s knowledge, the court believed this did not exempt the seller. The NCC emphasized the impracticality of attributing knowledge/actions solely to the seller’s directors and officers in M&A transactions to prevent moral hazards.

The ruling highlights the risk of information asymmetry between a seller and its portfolio company’s management, potentially exposing sellers to unforeseen liability loopholes. Sellers are advised to be actively engaged in the M&A process and consider detailed provisions in transaction documentation to clarify the attribution of information and knowledge to the seller.

While the NCC held the seller liable for damages, the buyer’s ability to recover losses could be challenging, especially if the seller has limited assets or if the buyer’s recourse is tied to insurance. Sellers should be aware of these risks and take steps to protect themselves from potential liabilities arising from the actions of their portfolio company’s management.