M&A Report – When the Contractual Rubber Meets the Statutory Road: Drafting Contractual Survival Provisions in Light of State Law Statutes of Limitations

March 20, 2014

Acquisition agreements typically contain provisions purporting to set the period in which the parties can make post-closing claims arising under the agreement.  For example, an agreement might provide that most representations and warranties "survive" for one year after the closing, while claims for breaches of certain "fundamental" representations and warranties "survive" indefinitely or forever.  Although practitioners typically draft these so-called "contractual survival provisions" without reference to applicable laws, such laws, and in particular laws concerning the statute of limitations, can have a significant effect on how courts will interpret such provisions.  We examine below how the laws of Delaware can affect contractual survival provisions.  We focus especially on the interplay between contractual survival provisions and the Delaware statute of limitations.

Choosing the Right Law

Before parties to a contract can assess the effect of state law on a contractual survival provision, they must first determine the applicable state law.  Not only does the applicable state law set the default statute of limitations, but it will also significantly affect the ability of parties to a contract to modify such statute.  For example, Delaware law gives parties greater flexibility to shorten the statute of limitations contractually than the laws of California and New York.[1] 

In particular, parties should consider whether an agreement’s choice of law provision requires the application of the selected state’s statute of limitations.  While the parties might intend that a generically worded choice of law provision cover the statute of limitations, generic language may be insufficient to require the application of a particular jurisdiction’s statute of limitations because a statute of limitations is often treated as a procedural, rather than substantive, issue for choice of law purposes.[2]  This treatment means that a court could look to the laws of the state in which it sits, rather than the laws selected in a contract’s choice of law provision, in evaluating statute of limitations issues.[3]  Practitioners may want to add language to the contract’s choice of law provision that explicitly addresses the treatment of statute of limitations issues as substantive or procedural or explicitly provides that a particular state’s statute of limitations will apply.  In addition, it may be appropriate to consider statute of limitations issues when negotiating venue provisions because the court may apply its local law on procedural issues, which may include the statute of limitations.

The Delaware Statute of Limitations

Section 8106 of the Delaware Code sets the Delaware statute of limitations for breaches of contract, providing that "no action based on a promise . . . shall be brought after the expiration of 3 years from the accruing of the cause of action . . . ."[4]  Although parties may contractually shorten this statute of limitations under Delaware law, they are prohibited from extending it.[5]  While some authorities have argued that this prohibition stems from underlying policy reasons, then Chancellor (now Chief Justice) Strine noted that while a "freely made contractual decision among private parties to shorten, rather than lengthen, the permitted time to file a lawsuit does not violate the unambiguous negative command of [the statute] . . . a decision to lengthen it does and allows access to the state’s courts for suits the legislature has declared moribund."[6]

In light of this prohibition, many contractual survival provisions in Delaware acquisition agreements are unenforceable.  It is not uncommon for these provisions to attempt to extend the statute of limitations beyond three years for breaches of certain fundamental representations and warranties, such as representations and warranties concerning ownership and organization of a target company and authorization to effect the transaction.  Parties seeking to extend the duration of the claims period for breaches of certain representations and warranties beyond three years may, therefore, want to consider the options available to extend the claims period, including careful drafting to determine when a claim accrues and drafting contracts under seal.[7]  We discuss both of these approaches below.

Determining When a Claim Has Accrued

A breach of a representation or warranty in an acquisition agreement will generally be deemed to accrue at the closing.[8]  A claim resulting from such a breach, therefore, could only be brought within three years of the closing date.  However, at least one court has distinguished between "direct claims" for breach against a contract counterparty for damages consisting of the diminution in value of the transferred assets and "claims for damages paid to third parties."[9]  While finding that direct claims for breach of representations and warranties accrued at the closing, the court observed that indemnification "[c]laims for third-party liabilities accrue in accordance with principles of common law indemnity."[10]  In other words, the applicable statute of limitations for such indemnification claims does not begin to run until "the indemnifiable losses to the third parties were incurred and the dispute with them concluded."[11]  The court was clear to note that the contract’s description of remedies as "indemnification" was not sufficient to turn each of the plaintiff’s claims for breach into a claim for common law indemnity; rather, the nature of the claim controlled.  As a result, claims made under an agreement that requires a seller to indemnify a buyer for losses arising out of a breach of representation or warranty may be subject to a three-year statute of limitations commencing at the closing with respect to direct claims by the buyer against the seller, while the statute of limitations for indemnification claims based on losses incurred by the buyer to third parties would not commence until payment was made to the third party.

In light of this differing treatment of claims and the confusion it likely engenders, practitioners may want to take into account the nature of each type of potential claim when drafting contractual survival provisions.  While claims directly against a seller for a breach of its representations and warranties may accrue at closing, parties may want to provide separately for claims arising out of liabilities to third parties to help bolster the argument that the statute of limitations for such claims does not commence at the closing.  Because these claims accrue once the obligation to the third party arises, and not necessarily at the closing, appropriate drafting may permit the parties effectively to extend the survival period for these obligations.  Similarly, drafting stand-alone indemnification obligations covering matters such as environmental, product liability or regulatory compliance claims, rather than relying on contractual indemnification for such matters based on breaches of representations and warranties, may permit such claims to be brought more than three years after the closing because they are not based on a breach that was deemed to have accrued at the closing.

Executing the Contract Under Seal

Another method of extending the claims period for breaches of representations and warranties is to cause the contract to be executed under seal. A contract executed under seal will have a common law statute of limitations of twenty years, rather than the statutorily mandated three years.[12]  Because, as noted above, the parties to a contract can agree to shorten the otherwise applicable statute of limitations, a sealed contract would permit the parties to extend liability for breach of certain "fundamental" representations up to 20 years, while agreeing to a significantly shorter period of liability for breaches of other representations.

The Delaware Supreme Court has held that an individual may create a sealed instrument by placing the word "seal" next to the individual’s signature, "irrespective of whether there is any indication in the body of the obligation itself that it was intended to be a sealed instrument."[13]  However, the Court did not specify the steps that a corporation or other entity, as opposed to an individual, would need to take to create a sealed instrument.  Accordingly, it is recommended that entities seeking to make a contract under seal should:

• obtain an authorization by each entity’s governing body to execute the document under seal in the resolutions authorizing the transaction;

• include clear language in the contract that the parties intend for the contract to be under seal;

• include a testimonium clause on the signature pages that affirms that the parties have both signed and sealed the contract; and

• affix a seal that has been adopted by the governing body of each entity, and not just the word "seal," next to each party’s signature.

Other Issues to Consider When Drafting Contractual Survival Provisions

In addition to the issues described above, parties should carefully consider the effect of contractual survival provisions restricting the statute of limitations.  Contractual survival provisions often require the non-breaching party to give notice of a claim prior to the end of the survival period in order to make a valid claim.  However, despite the language of the contract, giving notice of a claim within the contractually shortened limitations period may not be sufficient to preserve the claim.  A court may determine that the contractual survival period shortens the otherwise applicable statute of limitations and require the parties to bring suit, and not just give notice, before the end of the contractual survival period.[14]  Therefore, parties seeking contractual indemnification may be advised to file a claim prior to the expiration of the contractual survival period in order to ensure their rights are preserved.  Another alternative might be to get a clear waiver of any limitations period after delivering notice of the breach.[15]  In any event, even if notice of a claim is given within a contractual limitations period, the party making the claim must be mindful of the statutory limitations period and not allow it to lapse prior to filing suit. 

Conclusion

State law may affect superficially simple contractual survival provisions in unexpected ways.  Drafting parties should consider the effect that state law, including state statutes of limitations, will have on the contractual survival provisions contained in an agreement to avoid unintended consequences.

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