Andrew Lucano
Fraud carve-outs in M&A agreements, which create exceptions to negotiated contractual limitations on liability such as caps, baskets, survival periods and exclusive remedy provisions, have become a near-universal feature of private company M&A transactions. Their ubiquity, however, only heightens the importance of careful drafting.
How fraud is defined, and whether it is defined at all, can have profound consequences for post-closing risk allocation. Buyers, depending on their bargaining position, may seek broadly drafted fraud carve-outs to preserve maximum post-closing remedies. From a seller’s perspective, however, vague or overbroad drafting can transform a provision intended to preserve recourse for intentional deception into a mechanism that expands liability far beyond that.
A Hypothetical Scenario
A simple hypothetical illustrates the point. In the stock sale of NorthStar Software, a fictional provider of healthcare industry software, the seller negotiated narrowly tailored representations and warranties that did not survive closing. The agreement also included robust non-reliance language expressly disclaiming any representations regarding customer relationships. However, both the non-survival provision and the non-reliance language incorporated fraud carve-outs.
Shortly after closing, the buyer contacted NorthStar’s largest customer to introduce itself. To the buyer’s dismay, the customer informed the buyer that it would not renew its contract upon expiration, citing historical disputes with NorthStar. Despite the buyer’s efforts to salvage the relationship, the customer ultimately declined to renew. The buyer then asserted a fraud claim against the seller based on an informal, off-hand remark made during due diligence by a newly hired member of the target company’s management team: “Every one of our customers is very happy with us.” The buyer argued that this statement constituted a reckless misrepresentation related to the transaction, and invoked the fraud carve-outs, which were broadly drafted, to bypass all negotiated limitations on seller liability. Although the agreement expressly excluded representations about customer relationships and provided that representations did not survive closing, and despite there being no allegation that the speaker even knew of the customer’s dissatisfaction, the seller nonetheless faced uncapped exposure based on an informal, extra-contractual statement.
While hypothetical, this scenario reflects a real risk for sellers in M&A transactions. When fraud is undefined or defined too broadly, a fraud carve-out intended to preserve recourse for intentional misconduct, can expose the seller beyond the parties’ negotiated allocation of risk.
Trends in Defining Fraud
Seyfarth’s annual Middle Market M&A SurveyBook show that sellers are increasingly addressing the risks inherent in fraud carve-outs by defining fraud with greater precision. Fraud was defined in 69 percent of non-RWI deals and 99 percent of RWI deals that included a fraud carve-out, up from 31 and 60 percent, respectively, in Seyfarth’s 2020 SurveyBook.
Guidance from Delaware Case Law
From a seller’s perspective, fraud carve-outs should be drafted to mirror the public policy-based fraud exception established by the Delaware Court of Chancery in the 2006 case of ABRY Partners V LP v. F&W Acquisition LLC. In ABRY, the court held that sellers cannot contractually insulate themselves from liability for tort-based fraud claims arising from knowingly false representations contained within the four corners of the agreement.
While ABRY establishes a level of seller exposure to tort-based fraud claims as a matter of public policy, an express contractual fraud carve-out is typically intended to permit contractual-based indemnification claims for fraud by creating an exception to negotiated limitations on indemnification and/or, in some cases, by establishing a specific contractual indemnity for fraud claims. Contractual indemnification claims may be easier for buyers to prove than tort-based fraud claims and, in some cases, may be asserted against parties who could not be held liable for tort-based fraud. As the NorthStar hypothetical illustrates, if a contractual fraud carve-out does not incorporate the limiting principles reflected in ABRY, a seller may face liability far beyond what it bargained for.
Best Practices for Drafting Agreements
From the seller’s perspective, a well-drafted agreement including fraud carve-outs typically incorporates several key features. First, sellers should define fraud to require actual knowledge of falsity and intent to deceive, rather than recklessness, negligence or constructive knowledge. Many agreements further refine this standard by specifying whose knowledge is relevant, thereby limiting fraud-based liability to misrepresentations made by designated individuals with actual knowledge of the relevant facts.
Second, sellers should limit fraud to misrepresentations made within the four corners of the transaction documents. This limitation prevents extra-contractual statements from serving as a basis for contractual liability or from bypassing negotiated limitations on liability.
Third, sellers should include an effective disclaimer of reliance on representations or other statements made outside the agreement. In Fortis Advisors LLC v. Johnson & Johnson (NYSE: JNJ), the Delaware Court of Chancery held, and recently, on January 12, 2026, the Delaware Supreme Court affirmed, that the public policy fraud exception recognized in ABRY may apply to extra-contractual statements unless the agreement contains a clear and effective non-reliance provision. Notably, although the absence of an effective non-reliance provision typically exposes sellers to liability, in Fortis, the seller asserted the fraud claim against the buyer based on an extra-contractual statement relating to the seller’s earn-out payment. From a seller’s perspective, fraud carve-outs are generally not appropriate within the disclaimer of reliance itself because this provision by design alleviates liability that could arise from extra-contractual statements. A fraud carve-out using a definition of fraud tailored in favor of the seller would apply only to representations made within the agreement making moot the addition of a fraud carve-out in this instance.
Fourth, where a fraud carve-out is used, the agreement should clearly specify who may be liable for fraud. For example, if one seller had actual knowledge of a fraudulent misrepresentation and another did not, the agreement should clarify whether only the knowing party is subject to liability beyond the negotiated limitations. Limiting liability to the party with knowledge aligns with ABRY, as the tort-based fraud claim preserved by ABRY’s public-policy exception imposes liability only on those with knowledge of falsity.
Similarly, if fraud carve-out applies to non-recourse provisions that otherwise shield non-parties from liability, such as equity holders or employees the carve-out should be narrowly tailored to apply only to the individual with actual knowledge of the falsity.
Finally, parties should carefully consider whether, and how, fraud carve-outs are included in exclusive remedy provisions. Although Delaware courts have applied ABRY to overcome exclusive remedy clauses in cases of intentional fraud, an overly broad contractual fraud carve-out may allow buyers to avoid negotiated indemnification procedures, bypass survival periods for contractual indemnification claims and tort-based fraud claims, or assert contractual fraud claims against a seller that lacked actual knowledge of the alleged misrepresentation.
Had some or all of these drafting considerations been incorporated into the NorthStar hypothetical, the seller likely would have avoided exposure altogether. The statement was made outside the agreement, the speaker lacked actual knowledge of falsity, and the speaker may not have been a covered person under the fraud definition.
Although fraud carve-outs routinely appear in private M&A agreements, the way fraud is defined, if at all, plays a critical role in allocating risk after closing.
