Private Equity Newsletter

October 02, 2017

Read the latest edition of the "Private Equity Newsletter." This edition of Dechert’s Private Equity Newsletter reviews recent developments in private equity worldwide, including:

  • The Dangers of Undefined Fraud Carve-Outs and “Inelegant Drafting”
  • Recent Developments in Acquisition Finance
  • Update: Purchase Price Adjustment Disputes: Drafters Continue to Beware
  • The DOL's Fiduciary Rule and Sales/Marketing Activities
  • The Good and the Bad from OCIE’s Cyber Examinations and What Firms Should Do Next
  • ILPA Issues Guidance on Use of Subscription Credit Facilities


The Dangers of Undefined Fraud Carve-Outs and “Inelegant Drafting”

By Christian A. Matarese and Shannon Cleary

Crucial to any private equity seller is certainty: the certainty that a sale will be consummated at an agreed price and that any potential post-closing liability is fully understood in advance of distributing proceeds to limited partners. The recent Delaware decision, EMSI Acquisition Inc. v. Contrarian Funds LLC, C.A. No. 12648-VCS (Del. Ch. May 3, 2017) underscores how an imprecisely drafted fraud carve-out can strip private equity sellers of this certainty and open the door to long, costly and unpredictable legal battles. 

Fraud carve-outs under Delaware law are understood within the framework of the seminal decision of Abry Partners V, L.P. v. F&W Acquisition LLC 891 A.2d 1032 (Del. Ch. 2006): fraud claims based on extra-contractual representations and warranties (“R&Ws”) can be precluded if the buyer expressly disclaims reliance upon any extra-contractual statements, but common law fraud claims based on contractual R&Ws cannot be precluded or even confined to a negotiated cap because, as a matter of public policy, the available remedies for fraudulent contractual R&W’s cannot be contractually limited where a seller knows that the target company’s contractual R&Ws are false or where a seller itself lies to a buyer about such R&Ws.

In the EMSI case, the buyer made a post-closing indemnification claim against the sellers, most of whom were former institutional investors in EMSI (who had neither managerial oversight nor a participatory role in the preparation of financial information used in making R&Ws in the purchase agreement), for allegedly fraudulent R&Ws in the purchase agreement regarding EMSI’s financial position. These R&Ws were made by the target company, not the investors themselves who were selling their stakes in EMSI, but under the indemnification provision, the sellers agreed to indemnify the buyer for breaches of R&Ws made by the target company. With the cap on post-closing indemnification claims by the buyer against the sellers already reached, the buyer commenced an action in the Delaware Chancery Court, arguing that the fraud carve-out to the liability cap made the sellers, including all institutional sellers, liable for uncapped damages for fraud. 

The sellers argued that, although the buyer could make a claim based on a breach of the target company's R&Ws, the buyer could not make a claim for uncapped damages, as such a claim was not contemplated by the indemnification provisions of the purchase agreement. The sellers rooted their argument in a provision of the purchase agreement that stated that: 

[n]otwithstanding anything to the contrary in this Agreement (including, without limitation, Section 10.2 [Indemnification])…: (b) The Buyer Indemnified Parties shall not be entitled to indemnification under Section 10.2(a) for any and all Losses… in excess of… any then-remaining Escrow Funds. 

The buyer, on the other hand, argued that since the sellers stood behind the target company’s R&Ws, the undefined “fraud” carve-out in the contract meant that a fraudulent breach of those R&Ws exposed the sellers to uncapped liability for any and all losses suffered by the buyer, directing the court to the following broad and undefined fraud carve-out:

[n]otwithstanding anything in this Agreement to the contrary (including… any limitations on remedies or recoveries…) nothing in this Agreement (or elsewhere) shall limit or restrict (i) any Indemnified Party’s rights or ability to maintain or recover any amounts in connection with any action or claim based upon fraud in connection with the transactions contemplated hereby… (emphasis added). 

The parties each stressed a different interpretation of the non-reliance provisions, fraud carve-outs related thereto and cap on liability. The buyer asserted that the contract went further than Delaware’s public policy necessitated by creating a category of claims “based upon fraud” so, although the alleged fraud was the target company’s and the sellers themselves may have been unaware of the fraudulent misrepresentation, the broad carve-out enabled the buyer to make an indemnification claim against the sellers that was based on the target company’s alleged fraud. The sellers maintained that the liability cap, which had already been met, precluded the buyer from recovery of any additional damages, and the buyer asserted that such cap should not be applied since the purchase agreement expressly permitted uncapped claims for any action or claim based upon fraud. Had the fraud carve-out been more narrowly tailored, and precisely drafted, so as to limit exposure as much as allowed under the Abry framework, the buyer would have needed to show that the sellers knew that the target company’s contractual R&Ws were false to claim uncapped remedies. 

The Court of Chancery was tasked with settling a dispute over ambiguous drafting and dueling provisions. It faced competing “notwithstanding” clauses and two reasonable readings of the contract, so Vice Chancellor Slights ordered the case to proceed to trial, finding extrinsic evidence discoverable through trial to be necessary to determine which provision should prevail. This outcome, which will likely involve a drawn-out and expensive process, is already a loss for the sellers.

A clear takeaway from EMSI is the importance of clear and cohesive drafting, particularly with respect to fraud and indemnification. Sellers will typically desire to limit the opportunities for a buyer to bring claims of fraud and buyers will often seek to use fraud carve-outs to preserve flexibility to bring uncapped claims. Clear definitions of fraud as well as unambiguous non-reliance provisions minimize the likelihood of unexpected liability for both parties, but in particular, should help a private equity seller to achieve its goals of certainty with respect to its ability to distribute sale proceeds after it consummates a transaction.


Recent Developments in Acquisition Finance

By Jeffrey M. Katz, Scott M. Zimmerman and  Benjamin Snyder

A delicate balance has evolved over time in leveraged acquisitions with respect to the nature of the contractual relationship between a target and its owners, on the one hand, and the debt financing sources of the buyer, on the other. Sellers are typically eager for buyers to lock in sufficient committed debt financing in order to successfully complete an acquisition, while financiers are wary of any direct contractual relationship with the sellers and potential legal exposure to them in the event the financing falls through for any reason. 

Customary structuring of a leveraged buyout thus positions the buyer as something of a “middleman” or intermediary between the seller and the acquisition financiers, whether in terms of the buyer being the party with the contractual right to enforce a financier’s financing commitment, or in terms of the buyer being the counterparty to an acquisition agreement with the seller that includes the seller’s agreements, made for the express benefit of the financier (though not a party), not to sue the financier for a failed acquisition.1 A recent Texas Supreme Court decision, discussed below, has given parties in this context something new to consider, and provides a cautionary note. And a recent New York federal district court decision, also discussed below, has given parties to credit facilities a novel issue or two to ponder. 

Can Loose Lips Still Sink Ships?

In the course of a competitive bidding process for a target, a bidder will often include a debt financing commitment as part of its bid package. The financing commitment strengthens the bid package, highlighting the bidder’s access to the debt financing needed to pay the purchase price. A debt financing commitment submitted with a bid package may typically be signed only by the financier. If the bid in question ultimately wins, the potential buyer would then further negotiate and finalize the acquisition agreement with the seller, at which time the debt financing commitment papers would also commonly be finalized and executed by the buyer and financier. The acquisition and financing transactions may then close sometime thereafter, contemporaneously.

But consider a situation in which, during the process of negotiating and finalizing the acquisition agreement and financing commitment, the financier makes various supportive statements, orally or otherwise, to the buyer (its client) to the effect that it stands ready, willing and able to provide the financing, that it supports the transaction and will close when needed, and statements to similar effect, and that the buyer is passing these statements along to the seller in the name of the financier, as the financier is making them. Suppose further that the deal then craters due to an adverse event at the target, and no acquisition agreement is ever signed. Correspondingly, no financing commitment papers are ever countersigned by the buyer or become fully executed. The target’s business thereafter fails, with no other buyers forthcoming. 

Owners of the target assert that, if not for the repeated assurances of the financier that the deal was on track, they would have taken certain remedial actions to address the adverse events at the target. They claim they failed to do so only because they justifiably believed the deal was on track, in reliance on the financier’s assurances as relayed to them by the buyer right up to the time the buyer walked away from the deal. The target’s owners claim that the financier is thus responsible for the losses they suffered, namely the amount by which the target’s value deteriorated in the course of the events in question. Target’s owners may point to the financing commitment executed by the financier and submitted to the sellers with the initial bid package. Given that ultimately the acquisition agreement was never signed and the buyer never countersigned the financing commitment, the fact that the financier had signed the financing commitment is not an unhelpful fact for the target’s owners in such circumstances, whether their claim against the financier is based on misstatements it had made or on a breach of contract theory.

First Bank v. Brumitt

This potential exposure is highlighted by First Bank v. Brumitt,2 a recent decision by the Texas Supreme Court. As the case illustrates, there can be exposure to a financier based on misstatements made by it in such circumstances, giving rise to a potential claim by a seller directly against it. And if such liability were imposed on a financier, the financier would likely turn around and seek indemnification from the buyer on any such account.

In First Bank, Richard Brumitt (Seller), owner of Southway Systems, Inc. (Target), proposed to sell his stock in Target to DTSG, Ltd. (Buyer). Buyer met with the president of First Bank (Financier) in order to finance the proposed acquisition. Buyer and Financier entered into commitment documentation for the financing. Buyer informed Financier of the “sense of urgency” that existed to close the acquisition, given the competing offers from other potential buyers.3 In response, Financier told Buyer that Financier could close the financing by the end of the year. That did not happen and, instead, over the course of the next fourteen months, Financier scheduled and then postponed multiple proposed closings, in each instance citing events outside of its control (e.g., regulatory changes affecting its lending process). Buyer contended that Financier was not giving the transaction proper attention, resulting in the multiple delays, and that Financier had compounded the problem by repeatedly making statements to Buyer to the effect that the loan would indeed be closing imminently. These statements subsequently were asserted to have been false and negligent misrepresentations on the part of Financier. 

Examples of Financier’s statements that were characterized by both Buyer and Seller as false and negligent and as grounds for liability included Financier’s oral statements that the closing would occur “in early March,”4 that it could commit to closing “in April or May,”5 and that it would close “no later than July 15,” and then “on August 4,”6 as well as its text message to Buyer stating, “you are approved.”7 On the basis of these statements by Financier, Buyer and Seller informed Target’s employees of the impending ownership change and began making transition arrangements. 

The loan ultimately never was made and the proposed acquisition never occurred. Target soon thereafter failed as a going concern. Buyer then sued Financier for lost profits and exemplary damages, among other things, and Seller intervened and joined the action as an additional plaintiff against Financier. The causes of action against Financier included breach of contract, with Seller asserting rights as an intended third-party beneficiary against Financier under the financing commitment letter, and negligent misrepresentation, based on the asserted reliance by both Buyer and Seller on Financier’s statements about the certainty and timing of the financing for the proposed acquisition. 

The trial court found Financier liable to each of Buyer and Seller under both breach of contract and negligent misrepresentation theories, for the deterioration in Target’s value from the time of Financier’s entry into its financing commitment with Buyer, which effectively equaled all of Target’s value at such time. Separate damages awards were ordered by the trial favor of each of Buyer and Seller, with the overall recovery from Financier being split roughly equally between them. 

Financier appealed, and on appeal the Texas appellate court affirmed the trial court’s ruling on the breach of contract claim, finding that Seller was entitled to recovery from Financier as a third-party beneficiary of the financing commitment letter between Financier and Buyer, since those parties had intended to confer a benefit on Seller by virtue of the commitment letter, namely to finance Buyer’s purchase of Target from Seller.8 The Texas appellate court, however, reversed the trial court’s ruling on the negligent misrepresentation claim and dismissed it, ruling that the losses incurred were adequately compensated for under the breach of contract claim.9

Texas Supreme Court Weighs In

The Texas Supreme Court, on further appeal, reversed the Texas appellate court on both the breach of contract and negligent misrepresentation claims.10 The court held that the debt commitment letter did not contain a “clear and unequivocal expression of the contracting parties”11 to make Seller a third-party beneficiary. The mere fact that Financier and Buyer were aware of the benefit to Seller of the financing commitment letter was not sufficient ground from which to infer that they had intended to benefit Seller, which they could have demonstrated only by expressly stating their intention to do so or by naming Seller in the commitment letter, which they had not done.12

Having thus ruled that Seller could not recover on breach-of-contract grounds, since it was not an intended third-party beneficiary of the commitment letter, the court then reversed the finding of the Texas appellate court on the negligent misrepresentation claim, reinstating it. The rationale employed by the appellate court in denying that claim, namely that Seller’s breach of contract claim should suffice, no longer applied. The Texas Supreme Court thus reinstated Seller’s action for negligent misrepresentation against Financier, and remanded it down to the lower court for further action, finding it to be a factual question as to whether Financier had provided information it should have known to be false and whether Seller had reasonably relied on such information to its detriment. As the trial court had already found Financier liable on the negligent misrepresentation claim, Financier’s prospects on remand seem dim. 

What this Means for Sponsors

An obvious takeaway from First Bank is that financing commitment papers can speak for themselves, and that characterizations by either a financier or buyer that are inconsistent with their terms, or otherwise contrary to fact, serve no one’s interests. To characterize and relay “in shorthand” what are typically the detailed conditions of a debt commitment letter, and to do so inaccurately or incompletely, in terms such as “buyer is approved” or “we’re all set to close next week,” can be misleading when the reality does not match the shorthand. As noted, to the extent liability were imposed on a financier in favor of a seller, an indemnity claim by the financier against the buyer is likely not far behind. The best policy in such communications is simply to limit them to the facts. 

Cumulus Media -- Too Much of a Good Thing?

Traditional principles of contractual interpretation include that a specific provision will override a more general one dealing with the same subject matter, and that a contract should be read as a whole, with meaning being given to each provision within it to the extent possible. Such principles are designed to give effect to the presumed intention of the contracting parties when they entered into the agreement in question. The US District Court for the Southern District of New York, in its analysis in Cumulus Media Holdings, Inc. v. JPMorgan Chase Bank, N.A.13 as to whether a proposed debt exchange transaction was permitted under the terms of a credit agreement, emphasized the “whole contract” approach. The court found as a matter of law that the credit agreement as a whole prohibited the proposed transaction, notwithstanding that certain particular provisions of the agreement seemed to permit it. 

Cumulus Media (Cumulus) was the borrower under a senior secured credit agreement entered into in 2013 that evidenced US$1.8 billion in outstanding term loans and an undrawn US$200 million revolving credit facility, undrawn because Cumulus could not comply with a leverage ratio test that was a condition to any revolving facility draw. Cumulus also had US$600 million in unsecured bonds (Bonds) outstanding that had been issued in 2011, maturing in May 2019. The term loan maturity was in December 2020, unless an earlier “springing maturity” in January 2019 was triggered, which would occur only if the outstanding principal amount of Bonds exceeded US$200 million at the end of January 2019. The undrawn revolving facility would terminate altogether in December 2018. 

The credit agreement prohibited the making of any payments by Cumulus to redeem, prepay or acquire any of the Bonds, with an exception for payments made pursuant to “any refinancing of [the Bonds] . . . permitted pursuant to the terms [of the credit agreement].”14 Thus, despite the general restriction on making payments on the Bonds, Cumulus could still refinance them. Presumably this was because a refinancing would include a later maturity date, thereby allowing the loans under the credit agreement to mature first. The credit agreement elsewhere defined “Permitted Refinancings” of Cumulus debt permitted to be incurred or outstanding under the terms of the agreement. Such “Permitted Refinancings” were allowed because they featured various protections for the lenders, such as that the refinancing debt would mature later than the refinanced debt, and that the refinancing debt would be subordinated to the loans under the credit agreement at least to the same extent as the refinanced debt, among other protections. 

In order to avoid triggering the early January 2019 maturity of the term loans, Cumulus sought to refinance the Bonds in a manner that would enable it also to utilize its revolving credit facility, which otherwise was unavailable due to Cumulus’ inability to comply with the relevant leverage-ratio test. The proposal was to have the existing revolving lenders, which included banks that generally were uninterested in waiving compliance with the leverage-ratio test, assign their revolving lending commitments to Bondholders, who as the new revolving lenders would then waive compliance with the leverage-ratio test and then effectively convert their Bonds into secured revolving loans under the credit agreement. These new revolving lenders would also extend about another US$100 million as an incremental revolving facility under the credit agreement. Cumulus would then have effectively completed a distressed exchange of all of its US$600 million face amount of Bonds for the new and incremental secured revolving loans in the total principal amount of about US$300 million (plus some equity interests in Cumulus). This proposal was desirable for all parties involved, except the term lenders, who would find themselves sharing their collateral under the credit agreement with an additional US$300 million or so of new ratably secured revolving loans under the credit agreement, in place of the unsecured Bonds to which they had been effectively senior. 

The term lenders objected to the proposed transaction on two grounds. First, they asserted that the transaction did not fall under the relevant exception for Bond repayments made in connection with a “refinancing . . .permitted under [the credit agreement],” since the proposed transaction did not qualify as a “Permitted Refinancing” as defined in the agreement. Since “Permitted Refinancings” were the type of debt refinancing specifically allowed under the credit agreement, other debt refinancings, such as the Bond refinancing pursuant to the proposed exchange transaction, were asserted as not being among those “permitted under [the credit agreement]” for purposes of the exception. 

Second, the term lenders noted that, although the amendments section of the credit agreement permitted the revolving loan leverage-ratio test to be amended with the consent of just the revolving lenders, another provision in the credit agreement prohibited Cumulus from amending any of its credit or debt instruments in a manner materially adverse to the credit agreement lenders. The term lenders claimed that the proposed transaction, which would spread their already thin collateral across the additional new revolving loans, would be materially adverse to the term lenders, who then comprised all of the lenders under the credit agreement. They therefore maintained that, in order to approve the proposed transaction, a waiver of such prohibition was needed from a majority of the term lenders, which Cumulus had not obtained. 

For its part, Cumulus asserted that the proposed transaction was indeed a “refinancing . . . permitted under [the credit agreement]” under the language of the relevant exception, since the proposed transaction would refinance and retire the Bonds and would not violate any express term of the credit agreement. Cumulus maintained that reading the phrase “refinancing . . . permitted under [the credit agreement]” to include only a “Permitted Refinancing” was too narrow a reading and unwarranted. On the issue of whether term lender consent was needed to waive compliance with the revolving loan leverage-ratio test, Cumulus asserted that the covenant in the credit agreement governing amendments to credit and debt instruments generally, which the term lenders were relying on, is overridden by the specific requirements of the amendments section of the credit agreement that directly addressed the question of which lenders would be needed to approve particular waivers and amendments of this credit agreement. 

In its decision, the court sided with the term lenders and disallowed the proposed restructuring transaction, holding that it would violate the terms of the credit agreement. But the court did not use the rationale that the term lenders had employed. The court reasoned that the credit agreement should be read as a whole, and focused mainly on the fact that all lenders under the credit agreement, both revolving and term lenders, had limited Cumulus’ ability to make payments on the Bonds other than through a refinancing of the Bonds. But the parties had also defined the types of refinancings of company debt that were protective of the lenders, as “Permitted Refinancings.” The court then found the decisive provision to be in another section of the credit agreement altogether, one on which neither Cumulus nor the term lenders had initially focused. 

The credit agreement contained a debt-incurrence covenant that allowed Cumulus to incur debt only if it fell within the scope of various negotiated debt baskets. The two baskets relevant in this context were (1) the basket for debt drawn by Cumulus under the credit agreement in the form of revolving and term loans and (2) the basket for Cumulus’ debt under the Bonds and under “Permitted Refinancings” of the Bonds. The court viewed the second of these baskets as certain proof of the parties’ intention to limit Bond refinancings to those qualifying as “Permitted Refinancings,” under which the proposed transaction in question did not qualify. Cumulus’ assertion that these baskets were permissive only, and thus could not be used as a basis on which to prohibit a transaction otherwise allowed under the credit agreement, fell on deaf ears with the court. So did Cumulus’ contention that the transaction would be seen as permissible once it was dissected into its two component parts (namely, the new revolver borrowing permitted under the first basket referenced above, and the resulting refinancing of the Bonds permitted by the exception for Bond repayments under a “refinancing . . .permitted under [the credit agreement]).”15

The court found that the second basket referenced above, allowing the debt of Cumulus under the Bonds or under “Permitted Refinancings” thereof, was so specific that it barred any debt incurrence in connection with a Bonds refinancing that did not qualify as a “Permitted Refinancing,” despite the fact that this basket was just one of various baskets under which debt could seemingly be incurred. Because the court viewed the parties’ intentions at the time of entering into the credit agreement as having been clear that any Bond refinancing would need to qualify as a “Permitted Refinancing,” and believing that the parties had never contemplated that revolving loans themselves would be used to refinance the Bonds, the court inferred a use-of-proceeds test on revolver draws from the credit agreement taken as a whole, imposing this test on revolver draws and thereby disallowing any revolver draw that would be used to refinance the Bonds in a refinancing that did not qualify as a “Permitted Refinancing.” The court was unswayed by Cumulus’ argument that each of the constituent parts of the proposed transaction fell within a particular basket under each of the various negative covenants at issue, stating that its ruling on the matter was “consistent with the intent evinced by the structure and context of the contract as a whole. . . . The credit agreement does not permit each component of the refinancing.”16

On the second issue, namely which lenders’ approval under the credit agreement was needed in order to waive application of the leverage-ratio test for revolver draws, the court sided again with the term lenders, finding that a waiver would be needed from them as well. The court ruled that both the more general provision in the credit agreement governing modifications of any of Cumulus’ credit or debt agreements, as well as the specific provision in the credit agreement governing amendments of this particular credit agreement, needed to be complied with. This second ruling appears to have followed the outcome on the first ruling discussed above, and ironically cuts the other way in terms of the court’s stated rationale for its first ruling, emphasizing as it did in that connection the need to read the contract as a whole and to give greater weight to specific provisions over more general ones. 

What this Means for Sponsors

The decision in Cumulus Media highlights the tension sometimes found between what parties to an agreement likely intended and what the agreement’s technical meaning may seem to accommodate. It is a reminder to sponsors, and well as to other parties to financing arrangements, that sometimes one can be overly eager in attempting to squeeze a proposed transaction into an exception or basket that only technically applies -- especially where the result would be either to read in an allowance for something that may be viewed as blatantly violating the spirit of an agreement, or otherwise to defeat the reasonable expectations of counterparties. 

Creativity in the structuring of transactions is essential, especially for distressed portfolio companies in which the company’s future is on the line. Yet, creativity needs also to be controlled and ultimately embodied in a structure that is defensible on its face as being in line with the substance and intent of existing agreements. 


1) This is one of the so-called “Xerox” provisions typically included in an acquisition agreement for the financier’s benefit. 
2) 519 S.W.3d 95 (Tex. 2017).
3) Id. at 100. 
4) Id
5) Id. at 101. 
6) Id
7) Id
8) First Bank v. DTSG, Ltd., 472 S.W.3d 1, 13 (Tex. App. Ct. 2015), rev’d sub nom., First Bank v. Brumitt, 519 S.W.3d 95 (Tex. 2017).
9) Brumitt, 519 S.W.3d at 101. 
10) Id.
11) Id. at 103.
12) Id. at 101. 
13) No. 16-9591, 2017 WL 1367233 (S.D.N.Y. Mar. 31, 2017).
14) Transcript of Hearing at 9, Cumulus Media Holdings, Inc. v. JPMorgan Chase Bank, N.A., No. 16-9591, 2017 WL 1367233 (S.D.N.Y. Feb. 24, 2017) (ECF No. 118).
15) Id. at 9.
16) Id. at 86.


Update: Purchase Price Adjustment Disputes: Drafters Continue to Beware 

By  Christian A. Matarese and Gillian L. Teo

In the Spring 2017 edition of Dechert’s Global Private Equity Newsletter, we reviewed the Delaware Court of Chancery’s decision in Chicago Bridge & Iron Company N.V. v. Westinghouse Electric Company LLC and WSW Acquisition Co., LLC (Del. Ch. December 5, 2016) (“Chicago”). The article, “Purchase Price Adjustment Disputes: Drafters Beware,” highlighted the need for practitioners to consider carefully the effects that post-closing purchase price adjustment provisions can have on seller’s representations and warranties and related remedies, as well as the effects such representations and warranties and related indemnification provisions can have on purchase price adjustments. 

Although the Delaware Supreme Court reversed the Court of Chancery in Chicago Bridge & Iron Co. N.V. v. Westinghouse Electric Co. LLC and WSW Acquisition Co., LLC (Del. June 27, 2017) (“Westinghouse”), holding that the Court of Chancery’s decision was too broad, practitioners should still continue to consider carefully the potential effects noted above. 

The Delaware Supreme Court’s decision in Westinghouse is also rather instructive. In Westinghouse, the Court took a holistic view of the purchase agreement when considering purchase price adjustment provisions. The Court focused its analysis on reading the purchase price adjustment provisions and the post-closing liability bar in terms of the function of these provisions together with seller’s representations and warranties, as a whole. The Court emphasized that (x) the net working capital adjustment was intended to measure changes in working capital between signing and closing and (y) in exchange for a purchase price of zero, Westinghouse agreed that its sole remedy if Chicago Bridge breached its representations and warranties was to refuse to close, i.e. Chicago Bridge would not be subject to post-closing monetary liability (the “Liability Bar”). 


  • Practitioners should not lose sight of the Court’s emphasis that the “basic business relationship between the parties must be understood to give sensible life to any contract.”
  • Buyers and sellers should consider carefully the function of GAAP in net working capital adjustments and how that relates to indemnification limitations applied to breaches of financial statement representations and warranties.
  • Buyers and sellers should clearly delineate the role of the independent auditor, arbitrator or expert (the “Independent Reviewer”) in connection with purchase price adjustment disputes, including specifying items that are not in the purview of the Independent Reviewer’s authority.

The Delaware Supreme Court’s Analysis and Holding

Focusing on the need to read and interpret purchase agreements holistically, the Court reversed the Court of Chancery’s decision. The Court held that Westinghouse’s GAAP compliance allegations were not within the scope of the Independent Reviewer’s authority as the post-closing purchase price procedure (“true-up”) was a “narrow, subordinate, and cabined remedy available to address developments affecting [seller’s] working capital … between signing and closing.”

Chief Justice Strine emphasized that the role of a purchase price adjustment is informed by its function in the purchase agreement. The outcome in this case turned on the specific language of the true-up, the scope of the Independent Reviewer’s authority and the role of the Liability Bar.

In its decision to apply the Liability Bar to Westinghouse’s effort to raise GAAP compliance claims through the true-up procedures, the Court noted that:

  • The true-up was not meant to aid Westinghouse’s investigation of the target business or provide a historical picture of the purchased business’s operations.
  • Purchase price adjustments account for the normal variations in businesses between signing and closing. As such, the carve-outs to the non-survival provisions of the merger agreement did not serve to carve GAAP compliance out of the Liability Bar but rather to clarify that Chicago Bridge could owe Westinghouse money after closing only as a function of changes in working capital.1
  • Based on its findings, the Court rejected Westinghouse’s allegation that it “gave up nothing in the Liability Bar because, through the [true-up], it could seek monetary payments by alleging that Chicago Bridge’s historical accounting treatment wasn’t GAAP compliant.”

The Court also noted that the specific language of the merger agreement had clearly circumscribed the role of the Independent Reviewer. The Independent Reviewer did not have a mandate to address any dispute that might arise from the merger agreement, as parties had already specified a set of disputes that the Independent Reviewer could resolve. The merger agreement stated in several places that the auditor was to act as an expert and not an arbitrator, thus limiting the scope of the Independent Reviewer’s domain. The Independent Reviewer did not have wide-ranging authority but was confined to a discrete set of narrow disputes. Importantly, these disputes did not include assessing if the seller breached its financial statement representations and warranties. 

Given the limited role of the Independent Reviewer and the fact that the non-survival provisions did not carve GAAP compliance out of the Liability Bar, the outcome of the case turned on the precise language used with respect to net working capital (specifically, what role GAAP compliance played in determining net working capital). The Court noted that the true-up in this case was similar to the true-up in OSI Systems, Inc., v. Instrumentarium Corporation (Del. Ch. March 14, 2006), a case in which the Court determined that only a single test applied — whether the seller consistently applied GAAP principles — and that the net working capital adjustment did not establish a separate GAAP compliance test. The Court held that to be the case in Westinghouse as well. For these reasons, the Court held that Westinghouse’s assertion that Chicago Bridge’s financial statements were not GAAP compliant should not be presented to the Independent Reviewer for its determination. 

Closing Thoughts

Both Chicago and Westinghouse should serve as important reminders to drafters that they need to focus on the purchase price adjustment provisions and the various other provisions contained in a purchase agreement and evaluate the interplay between all such provisions as a whole. In Westinghouse, Westinghouse attempted to circumvent the Liability Bar by arguing that Chicago Bridge’s financial statements were not in accordance with GAAP, but the Court determined that the zero purchase price, coupled with the Liability Bar, only made sense if both parties agreed that the transaction would enable Chicago Bridge to have a clean break from its subsidiary’s projects. To interpret the true-up broadly as the Court of Chancery did in Chicago would thus undermine the primary business deal.

Additionally, both parties should consider the role that they would like the Independent Reviewer to play in resolving disputes, and the kinds of disputes an Independent Reviewer should determine. It is important to ensure that language relating to such review process is unambiguous. 


1) The Court emphasized that buyers typically use working capital adjustments to protect against value depletion, citing an article co-authored by Dechert and Alvarez & Marsal: Working Capital Adjustments: At the Crossroads of Law and Accounting, N.Y.L.J. Oct. 26, 2015), which can be found in the Winter 2016 edition of Dechert’s Global Private Equity Newsletter.


The DOL's Fiduciary Rule and Sales/Marketing Activities

By Andrew L. Oringer

The U.S. Department of Labor on April 6, 2016 released the final version of its “investment advice” regulation and accompanying prohibited transaction exemptions (collectively, the “Final Rule”), a highly-anticipated milestone that is the culmination of a long and arduous process to adopt new rules relating to the definition of “fiduciary” under the Employee Retirement Income Security Act of 1974 (“ERISA”) and the Internal Revenue Code of 1986 (the “Code”). The Final Rule covers not only retirement plans that are subject to ERISA, but, controversially, also individual retirement accounts and certain other non-ERISA plans. Despite a good deal of controversy swirling about the Final Rule, including from within the Trump administration, the Final Rule, to the surprise of many, became effective, at least in part, as of June 9, 2017. One aspect of the Final Rule that could be of relevance to private equity sponsors, which might not be immediately obvious to some, is that the Final Rule could have adverse implications for a broad range of sales and marketing efforts, whether or not the parties doing the sales and marketing would otherwise be fiduciaries under the Final Rule. If a provider is considered to be providing "investment advice" at the sales/marketing stage, and if no exception or exemption is available, then there could at that juncture be a violation of ERISA's and the Code's prohibitions against certain self-dealing and conflicts of interest, in which case the investor (depending on the type of investor) may have remedies and excise taxes may become payable. This matter is discussed in Section IV(C) of our May 2016 OnPoint

Stay up to date with Dechert's Department of Labor's Fiduciary Rule Resource Page.


The Good and the Bad from OCIE’s Cyber Examinations and What Firms Should Do Next

By Timothy C. Blank, Kevin F. Cahill, Vernon L. Francis and Hilary Bonaccorsi

The Office of Compliance Inspections and Examinations (OCIE) of the U.S. Securities and Exchange Commission (SEC) released a National Examination Program Risk Alert (Risk Alert) on August 7, 2017 regarding observations from its cybersecurity-related examinations of 75 registered broker-dealers, investment advisers and investment companies (collectively, Firms).1 This OnPoint details the National Examination Program Staff’s (Staff’s) positive and negative findings from OCIE’s 2015 Cybersecurity Examination Initiative (Cybersecurity 2 Initiative) and summarizes the elements that the Staff identified as hallmarks of “robust” policies and procedures. 

The Staff’s examinations, conducted in connection with the Cybersecurity 2 Initiative, focused on Firms’ written policies and procedures regarding cybersecurity, and specifically drilled down on the six areas of focus that OCIE had identified in its September 15, 2015 Risk Alert regarding cybersecurity:2

  • Governance and risk assessment;
  • Access rights and controls;
  • Data loss prevention;
  • Vendor management;
  • Training; and
  • Incident response.

The Staff conducted the examinations between September 2015 and June 2016 and, during that time, it examined a “different population” of Firms from those that it had examined in connection with its 2014 cybersecurity initiative (Cybersecurity 1 Initiative).3

Although the Staff found that Firms’ cybersecurity preparedness had generally improved in the time since it conducted the Cybersecurity 1 Initiative, the Staff made clear that there were still several areas in which Firms could improve their cybersecurity-related controls. The Staff also identified for Firms what it believes to be “elements of robust policies and procedures” regarding cybersecurity. 

The Staff’s Positive Observations from the Cybersecurity 2 Initiative

The good news was that the Staff noted “an overall improvement in [F]irms’ awareness of cyber-related risks and the implementation of certain cybersecurity practices since the Cybersecurity 1 Initiative.” The Staff explained that, “[m]ost notably, all broker-dealers, all funds, and nearly all advisers” had written policies and procedures regarding cybersecurity and the protection of customer records and information. For example, “nearly all” Firms had policies and procedures that addressed regular system maintenance, cyber-related business continuity planning, and the SEC’s Regulation S-P (Reg. S-P) and Regulation S-ID. Most Firms also “maintained cybersecurity organizational charts” and detailed the cybersecurity roles and responsibilities of Firm employees. In addition, “nearly all” Firms had plans in place that addressed incidents related to unauthorized access, and the “vast majority” of Firms had such plans for denials of service and unauthorized intrusions.

With respect to third-party service providers, the Staff found that “almost all” Firms either conducted their own risk assessments of vendors or required those vendors to provide their security reviews and certifications to the Firm. In addition, over half of the Firms examined required that their vendors update their risk assessment responses at least annually. These findings were particularly encouraging in light of the fact that, in the Cybersecurity 1 Initiative, the Staff reported that 84% of broker-dealers and a much lower percentage of investment advisers required cybersecurity risk assessments of such vendors with access to their Firms’ networks.

From a technical standpoint, the Staff reported that “nearly all” broker-dealers and the vast majority of investment advisers and funds periodically conducted risk assessments of their critical systems, and that all Firms had a tool or system in place to monitor data losses involving personally identifiable information. In addition, “nearly all” broker-dealers conducted penetration tests and vulnerability scans on their critical systems; however, less than half of advisers and funds did so, and a number of Firms did not “fully remediate” “high risk observations” identified via those tests and scans. Similarly, although the Staff explained that “all broker-dealers and nearly all advisers and funds” conducted regular maintenance on their systems and installed software patches to address vulnerabilities, a few Firms failed to install patches that included critical security updates. The Staff also identified these shortcomings related to the remediation of known vulnerabilities as “issues” in the Risk Alert.

Issues Observed During the Cybersecurity 2 Initiative 

But these positive findings were not all the Staff found: the Staff also identified issues that Firms should work on resolving as they seek to “assess and improve” their cybersecurity programs. The Staff explained that the majority of Firms’ written policies and procedures “appeared to have issues.” The Staff noted that some policies and procedures were “vague,” provided “only general guidance” and were “not reasonably tailored” to suit the Firms’ needs. They reported that some Firms did not actually enforce their policies and procedures, and that in some cases the policies and procedures depicted by Firms did not accurately describe their actual practices. For example, certain written policies might require annual “customer protection” reviews or the completion by employees of cybersecurity training, but, in practice, reviews were conducted either less frequently than annually or employee trainings did not occur at all. Furthermore, the Staff observed issues related to Reg. S-P violations, noting specifically that certain Firms did not properly conduct system maintenance because they failed to install security patches, timely update their operating systems or fully remediate high-risk findings they had identified when conducting penetration tests and vulnerability scans on their systems.

Best Practices Identified During the Cybersecurity 2 Initiative

The Staff identified certain elements that were included in certain Firms’ “robust” policies and procedures and that serve as examples of best practices for Firms to consider. The elements of these robust policies and procedures included:

  • Maintaining a complete “inventory of data, information and vendors;”
  • Delineating “detailed cybersecurity-related instructions” – for example, with respect to “access rights,” this could include tracking requests for access and having policies and procedures specific to the modification of certain access rights (such as when a new employee comes on board, a position is terminated or an employee’s role changes);
  • Maintaining “prescriptive schedules and processes for testing data integrity and vulnerabilities,” such as by testing a patch before deploying it Firm-wide and analyzing the risks related to and the effectiveness of the patch; 
  • Establishing and enforcing “controls to access data and systems,” through, for example, acceptable use policies and policies that require third-party vendors to log their network activities;
  • Requiring mandatory employee training at the time of hire and on a periodic basis thereafter; and
  • The vetting and approval of the cybersecurity policies and procedures by senior management.

The Staff encouraged Firms to review the enforcement actions brought against Firms for violations of the Safeguards Rule of Reg. S-P as an additional source for guidance regarding the Staff’s expectations.4

Takeaways from Staff’s Findings of Firms “At Risk” Regarding Cyber-Readiness

Despite the observed overall improvement in Firms’ awareness of cyber-related risks, the Staff’s findings demonstrate that a number of Firms have some way to go in order to achieve cyber-readiness. The specific shortcomings that the Staff identified involve elements that should be considered basic components of an effective cybersecurity program, meaning that the absence of those components in Firms’ policies and procedures may expose those Firms to increased cybersecurity risks.

For example, when a Firm’s policies and procedures are “not reasonably tailored” or a Firm relies on “form-of” policies, the Firm runs a risk of having a shell policy that provides little direction and does not encourage those responsible for the policy to effectively protect the Firm’s customer information or systems. Similarly, a Firm’s failure to “say what you do and do what you say” increases the likelihood that a policy exists only on paper, which can lead a Firm to take ad hoc approaches to cyber threats that are both inconsistent and ineffective, and can also lead a Firm to violate its compliance policies and procedures. 

As recent hacks have reminded companies, the failure to remedy and patch known system vulnerabilities may make a Firm a “sitting duck” target for hackers who seek to exploit those vulnerabilities, exposing customer information to theft and leaving the affected Firm without an argument that it could not have reasonably prevented the breach. In these situations, an affected Firm may be exposed not only to increased cybersecurity risks but also to regulatory risks, given the Staff’s expectation that registrants have in place and actually implement tailored cybersecurity policies that adequately protect their systems.


The improvements Firms have made since the Cybersecurity 1 Initiative are important and have not gone unnoticed by SEC Staff. Nevertheless, the “issues” and shortcomings identified by the Staff in the Cybersecurity 2 Initiative should not be taken lightly, as the deficiencies identified amount to key components of a basic cybersecurity program. 

All Firms – even those who have done so recently – should take a careful look at the written policies and procedures they have in place, and at how they implement their cyber controls in practice, to ensure that they do in fact have a tailored cybersecurity program that is actually implemented and works effectively to remediate known vulnerabilities and threats. Once a Firm is comfortable that it has those basic elements in place, it should look for ways in which it can further improve its processes and controls related to cybersecurity and, at the Staff’s suggestion, should use the examples of “robust” controls and findings from the Staff enforcement actions under Reg. S-P as a guide. The Staff’s summary shows that many Firms have more work to do in this space and that the Staff remains focused on what it has described as “one of the top compliance risks for financial [F]irms.”


1) Observations from Cybersecurity Examinations.
2) For further information regarding the Cybersecurity 2 Initiative and OCIE’s September 15, 2015 Risk Alert, please see Dechert OnPointSEC Cybersecurity Examinations and Enforcement: What Broker-Dealers and Investment Advisers Need to Know.
3) The Cybersecurity 1 Initiative was announced on April 15, 2014 and the Staff summarized the examination findings in a February 3, 2015 Risk Alert. For further information regarding the Cybersecurity 1 Initiative and the related findings, please see the following Dechert OnPointsSEC Staff to Conduct Broker-Dealer and Investment Adviser Examinations Focused on Cybersecurity and The Evolving U.S. Cybersecurity Landscape: What Firms Want to Know.
4) Please see In re Morgan Stanley Smith Barney LLC, Exchange Act Release No. 78021, Advisers Act Release No. 4415 (June 8, 2016); In re R.T. Jones Capital Equities Management Inc., Advisers Act Release No. 4204 (September 22, 2015); and In re Craig Scott Capital LLC, Exchange Act Release No. 77595 (April 12, 2016) for further information.


ILPA Issues Guidance on Use of Subscription Credit Facilities

By Philip Butler, Christopher Gardner,  Smridhi Gulati and Nathalie Sadler

The Institutional Limited Partners Association (“ILPA”), the body that represents the international limited partner community, has recently issued a best practice guide to assist both investors and managers1 with the use of subscription lines in a fund context (the “Guide”). The Guide is the result of a collaboration between ILPA, investors, managers and other industry advisers and has been issued in response to investors’ increasing focus on the area2 in light of the trend of managers looking to expand the use of such facilities.

The Guide includes nine recommendations as well as a list of recommended due diligence questions. Broadly, the Guide encourages increased dialogue, both before subscription lines are put in place and afterwards, by way of investor reporting.

Whilst the Guide focuses on private equity funds, it is likely to be of use to stakeholders in other closed-ended private funds, including private debt funds.

Use of Subscription Lines

Subscription lines have long been a feature in the private fund context (particularly for short-term bridging purposes and to smooth the capital call process) but, over recent years, there has been a move to expand their use to allow for longer-term borrowing. Subscription lines were traditionally only lent against the covenant strength of, and secured against, the uncalled commitments of investors. However, more recently, as managers have sought greater flexibility in the use of subscription lines (particularly in the case of private debt funds), they have been advanced not only against uncalled capital commitments but also against the net asset value of the underlying portfolio assets and portfolio investment cash flows. For certain longer term financing, a hybrid of these products is increasingly being considered, with lenders looking for recourse from both undrawn commitments and underlying portfolio assets. In each case, such facilities allow a manager to manage deal execution as well as, in certain cases, enhancing returns and maximising the use of a fund’s available capital. Their use is generally charged as an expense of the fund (and is therefore ultimately borne by investors).

While the traditional use of subscription lines can be beneficial to investors (helping them manage cash flow and administrative burden), they can prove controversial. The debate has focused particularly on the impact on the internal rate of return (“IRR”) of the fund (making performance look more impressive relative to managers not using such facilities) and to carried interest3. In addition, to the extent a fund is reliant upon a subscription line, it is (and its investors are) further exposed to the actions of a lender withdrawing the subscription line due to a breach of the subscription line documentation with the perceived risk increased in the case of more complex hybrid subscription lines.

Practical Changes for Managers

Managers should expect an increased focus from investors on this issue, who will likely have regard to the terms and recommendations of the Guide.

The key practical changes managers should expect are set out below:

  • Reporting. The Guide includes specific information that ILPA recommends should be included in quarterly reports, including: (i) the balance and percentage of outstanding called capital (to provide a sense of the relative use of subscription lines by the fund); (ii) the current use of proceeds from subscription lines; (iii) the terms of and costs to the fund of such subscription lines; and (iv) the net IRR with and without the use of such subscription lines. On a similar note, the Guide also suggests certain disclosure obligations be included in the fund’s constitutional documentation (which are discussed under “Fund Documentation” below) and that investors sitting on advisory committees add the use of subscription lines as a discussion item to meeting agendas.
  • Subscription Line Policy. The Guide encourages managers to develop a policy on subscription lines and to include this as part of the due diligence information available to investors4. Managers should therefore be prepared to be asked for this.
  • Using Subscription Lines to Cover Fund Distributions. The Guide discourages managers from using subscription lines to cover fund distributions in anticipation of (but prior to) a portfolio company exit. This provision seems most applicable to private equity funds but could conceivably be applied in respect of a private debt fund (i.e., where a significant debt investment is disposed of). This appears to be a similar concept to the ‘asset stripping’ rules set out in the E.U. alternative investment fund managers directive.
  • Standard Questions. The Guide includes a list of suggested due diligence questions. Some of these points require detailed and/or potentially sensitive information to be considered and disclosed, such as the recourse a lender has to uncalled commitments upon an event of default and the cost to renew the subscription line. Again, managers should aim to prepare answers to these questions to ensure the smooth running of investor negotiations.

Fund Documentation

The Guide includes a number of recommendations that are likely to affect fund constitutional terms where a subscription line is used. Managers should be aware that certain points are more likely to be raised in a negotiation with investors now that they have been consolidated into the Guide.

In particular, in light of the recommendations, investors are likely to focus on the calculation of the preferred return payable in respect of a fund. Whilst this is currently generally calculated purely by reference to drawn commitments, ILPA suggest this should also take into account when a subscription line is drawn.

The Guide also suggests that the parameters of the use of a subscription line (including maximum limits on items such as the percentage of uncalled capital subject to subscription line exposure) should be clearly defined in the fund’s constitutional documentation. As documentation develops in response to this, managers will need to engage with their service providers at an early stage of planning a fund to define how they intend to use subscription lines.

ILPA also indicate that the requirement to disclose certain issues in relation to the use of subscription lines is clearly set out in the fund’s constitutional documentation, including specific information on the assets used to service the subscription line, information on applicable loan covenants and any terms of the line that may introduce additional risks.

ILPA advise that subscription lines should only be secured by investor commitments to the fund (and not the invested assets of the fund or the underlying assets of investors). The Guide also states that cross-collateralisation of subscription lines should be avoided.

Closing Thoughts

Whilst the Guide is not binding, it is likely to shape how fund documentation and subscription lines are structured in the future as the recommendations are likely to be persuasive in negotiations. Managers should be aware of the contents of the Guide when arranging subscription lines and be prepared to discuss their proposed use with investors in some detail, particularly where more complex hybrid subscription lines are being considered.


1) The Guide refers to limited partners and general partners but the principles of the Guide apply regardless of the legal form of the fund. Similarly, the Guide uses various terms for subscription lines of credit (subscription lines, credit lines, subscription facilities, credit facilities, etc.) – for simplicity we will refer to these as ‘subscription lines’ in this article.
2) It is anticipated that regulators will also start to focus on this area, particularly in relation to risk, costs and conflicts of interest. Please see Use by Private Equity Funds of Subscription Credit Facilities as a Form of Investment Leverage.
3) Where a subscription line is used and the preferred return is calculated on drawn commitments, carried interest will be payable pursuant to the waterfall provisions of the fund’s constitutional documentation more quickly than where the calculation of the preferred return takes into account when the subscription line was invoked. In such cases, the clawback provisions of the fund’s constitutional documentation are also more likely to be relied upon.
4) The Guide also encourages investors to ask managers to disclose the impact subscription lines have on their track record during the due diligence process.

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