Disclaimers of Reliance in Shareholder Settlements

Settlement agreements that disclaim reliance may provide a defense against a subsequent fraud claim.

But not always. When are disclaimers of reliance effective and enforceable? How do they effect claims of fraudulent non-disclosure. How do they affect claims of breach of fiduciary duties?

Fraud and Disclaimers of Reliance

Disclaimer of Reliance

The Texas Supreme Court has developed the use of a disclaimer of reliance as a defense to fraud in the inducement beginning with Schlumberger Tech. Corp. v. Swanson,  and continuing with Italian Cowboy  and Forest Oil,  and most recently IBM v. Lufkin Indus.  “[A] clause that clearly and unequivocally expresses the party’s intent to disclaim reliance on the specific misrepresentations at issue can preclude a fraudulent-inducement claim.”

     Threshold Test

The threshold test is whether the disclaimer of reliance was “clear and unequivocal.”  The initial inquiry is whether reliance has been disclaimed and whether the language of the disclaimer is “clear and unequivocal.” For instance, some courts have held that a disclaimer of reliance does not pass the threshold test if it does not use the word “rely.”  Therefore, care must be taken in the wording of the disclaimer. Efforts to sneak in the disclaimer by using softer language, such as “the parties are using their own judgment” probably won’t pass the threshold test. The language should state straightforwardly that the selling shareholder “has not relied on any statements, representations, or promises not stated in the Agreement.” However, does even this language disclaim reliance on non-disclosures? It would be difficult to argue that it “clearly and unequivocally” does. Therefore, the disclaimer should also include language disclaiming reliance and/or waiving the right to rely on any information not disclosed. This disclaimer can be strengthened by a representation and warranty that each party has done an independent investigation, that each party is relying solely upon their own information and judgment, and that each party accepts the risk that other information may exist that was not discovered.

     Extrinsic Factors

“Not every such disclaimer is effective, and courts ‘must always examine the contract itself and the totality of the surrounding circumstances when determining if a waiver-of-reliance provision is binding.’”  Basically, the Supreme Court cases require three things: (1) that the plaintiff did in fact promise to forego a future fraud claim; (2) that he did it knowingly and intentionally; and (3) that he did it voluntarily by having negotiated or having been able to negotiate the terms.  The first requirement is dealt with by the threshold test of a clear and unequivocal disclaimer. The second and third requirements are dealt with by examination of certain extrinsic factors: (1) whether the terms of the contract were negotiated, rather than boilerplate, and during negotiations the parties specifically discussed the issue which has become the topic of the subsequent dispute; (2) whether the complaining party was represented by counsel; (3) whether the parties dealt with each other at arm’s length; and (4) whether the parties were knowledgeable in business matters.  These are “factors,” not requirements,  and they are a non-exclusive list. When all four are present, the disclaimer is definitely enforceable: “When ‘sophisticated parties represented by counsel disclaim reliance on representations about a specific matter in dispute, such a disclaimer may be binding, conclusively negating the element of reliance in a suit for fraudulent inducement.’”

When not all of the factors are present, then the court is required to balance the public concerns of the necessity of finality in settlements against the possible unfairness of enforcing a disclaimer that bars an unknown fraud claim. In Allen v. Devon Energy, the court held that the disclaimer of reliance was clear and unequivocal, that the plaintiff had been represented by counsel,  and that the plaintiff was knowledgeable and sophisticated, but that the disclaimer terms had not been negotiated (the agreement was prepared by the defendant and the plaintiff was given only three days to read and sign) and the agreement was not at arm’s length because a formal fiduciary duty existed. The Allen court held that this was not enough to make the disclaimer enforceable because the factors that were present “focus on the public policy concern that the party may be unable to understand the terms of the disclaimer but not the concern that the party may be unable to alter the terms of the disclaimer.”  The court held: “Something more is required—either negotiated terms or an arm’s length transaction—both of which focus on the party’s ability to alter the disclaimer's terms so that a party voluntarily surrenders its rights to a fraud claim. One of these two factors can be satisfied by demonstrating that the party who agrees to the disclaimer either (1) did in fact negotiate the contract terms or (2) had the ability to negotiate terms because the parties dealt with each other at arm’s length.”

     Application to Fiduciary Duties

It is not at all clear that a normal disclaimer of reliance has any effect whatsoever on a claim of breach of fiduciary duties. “Unlike a fraud claim, a claim for breach of fiduciary duty does not require a plaintiff to establish reliance.”  The mere statement that the plaintiff had not relied on any statements of the defendant would not negate an element of breach of fiduciary duties.

If a “disclaimer” is to be useful to defend a settlement agreement against a later claim that it violated fiduciary duties, then what would be required is a waiver of fiduciary duties, independent of any disclaimer of reliance. Presumably the Forest Oil factors would still apply: the waiver would have to be “clear and unequivocal,” and it would be significant whether the language was actually negotiated or was boiler plate, whether the plaintiff was represented by counsel, and whether the plaintiff was knowledgeable and experienced in business matters. However, one of the Forest Oil factors would never be present: an arm’s length relationship. “A transaction between a fiduciary and the party to whom the fiduciary duty is owed is not conducted at arm’s length; rather, a heightened standard applies to the fiduciary’s part of the transaction.”  Even the existence of strained relations does not vitiate formal fiduciary duties.

Texas Standard Oil & Gas L.P. v. Frankel Offshore Energy, Inc.  bears some scrutiny. In that case, two business partners split up their business relationship and signed a settlement agreement that included a clear disclaimer of reliance. The plaintiff later sued for breach of fiduciary duties claiming that the settlement agreement was induced by fraud. The plaintiff argued that, because of the absence of an arm’s length relationship, the disclaimer was per se unenforceable, and the trial court concluded such a provision is enforceable only if the parties first contractually disavow a fiduciary relationship.  The court of appeals was plainly troubled by the specter that finality might be impossible between fiduciaries. “Axiomatically, fiduciaries, like any other business associates, might wish to ensure finality to their disputes. Thus, their expressed intent to ensure finality, via a fraudulent-inducement release or disclaimer of reliance, as well as their freedom to contract, should be accorded the same respect as the intent of other parties.”  The court refused “to adopt a blanket rule that such a provision in a settlement agreement between fiduciaries is unenforceable.” 

In Texas Standard, unlike in Allen v. Devon Energy, all the Forest Oil factors were present, except the arm’s length relationship,  and the court mitigated the impact of that factor by noting that the fiduciary duties had less force because the parties were in active litigation and the transaction was part of a settlement dispute.  Therefore, in a similar situation, one could argue that waivers of fiduciary duties should be enforceable.

The problem is that the issue in Texas Standard was plainly whether a release could be set aside based on fraud in the inducement when reliance was disclaimed.  Texas Standard applied the Forest Oil factors and held that the disclaimer barred fraud in the inducement. The plaintiffs in Texas Standard argued that a disclaimer of reliance was per se unenforceable on a fraud in the inducement claim between fiduciaries. The Court rejected that argument; however, the issue presented to and decided by the Court was the effectiveness of a disclaimer on a fraud in the inducement claim—a claim that can arise between fiduciaries but is not unique to the fiduciary relationship. The Texas Standard court did not decide the effectiveness of a fraud disclaimer on a breach of fiduciary duty claim in which reliance is not an element. That court also did not decide whether a fraud disclaimer changed the presumption of invalidity or the burden of proving fairness.

The Amarillo court of appeals demonstrated the application of this principle in Harris v. Archer.  There, the parties formed a partnership for the purpose of purchasing a building. Subsequently one partner bought out the other and days later sold the building for a $300,000.00 profit and had not disclosed the negotiations were on going at the time of the buy-out. The purchase agreement included a release of known and unknown claims.  The plaintiffs sued for breach of fiduciary duties. The defendants argued that the release and merger clause precluded the claim. The Court of Appeals held it did not and specifically distinguished the holding in Schlumberger.  In Schlumberger, the disclaimer was held to be binding. The facts presented in Schlumberger, however, included arms-length negotiations, discussions involving the very subject matter which the Swansons claimed was misrepresented to them, and the existence in the agreement of language specifically disclaiming reliance on statements or representations of other parties. Moreover, the Court clearly stated that even a disclaimer of reliance on prior statements and representations, or a merger clause, will not always bar fraudulent inducement claims, and that there was no evidence of a fiduciary or confidential relationship between the parties. In Harris, the court held that a breach of fiduciary duty claim could only be released if the material facts were disclosed or known. 

This post is taken from a recently published white paper: How to Fraud-Proof Shareholder Settlements. Download the entire white paper with complete analysis of the issues and full legal citations.

How to Fraud-Proof Shareholder Settlements