Corporate, Mergers & Acquisitions,
and Securities Alert
September 2008
Authors:
David J. Perry
+1.949.623.3531
david.perry@klgates.com
Jeffrey A. Shady
+1.949.623.3565
jeffrey.shady@klgates.com
Eric Simonson
+1.206.370.7679
eric.simonson@klgates.com
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Recent Ninth Circuit Opinion on California
Law Unfavorable to Reducing the Statute of
Limitations in Contracts
In the recently decided case Western Filter Corp. v. Argan, Inc. (9th Cir. 8-25-2008), the
United States Court of Appeals for the Ninth Circuit potentially threw a monkey wrench
into efforts by parties to acquisition agreements to limit the time post-closing available
for parties to make indemnification claims. Western Filter involved a question of whether
a provision in a stock purchase agreement permitting the representations and warranties
made by the contracting parties to survive closing for a limited period of time, also serves
as a contractual “statute of limitation” that reduces a longer period otherwise provided by
California law. As a general matter, contracting parties have previously felt comfortable
that claims for breaches of representations made after a contractual “survival” period
are barred. In applying California law, the Court in Western Filter strictly construed the
contractual provision at issue which on its face appeared to limit the right to make claims
for indemnification to claims made within one year of the closing. The Court held that the
one year limitation set forth in the survival clause serves only to specify when a breach of
representations and warranties may occur, but not limit the time period when an action must
be filed. This conclusion was surprising, and, we believe based on a misunderstanding of
how representations and warranties function in the context of a purchase agreement for a
business. Nevertheless, the holding, which would apply to purchase and other acquisition
agreements that invoke California law must be considered by parties negotiating and
documenting similar agreements under California law.
Background
Puroflow, Inc., a wholly owned subsidiary of Argan, Inc., designs, manufactures, and sells
industrial filtration products. Western Filter Corporation was a competitor until acquiring
all of Puroflow’s stock from Argan pursuant to a stock purchase agreement (“SPA”). Like
many other acquisition agreements, the SPA included a survival clause that provided that
the representations and warranties made by Western Filter and Argan “shall survive the
closing for a period of one year,” except that certain other specific representations and
warranties, which were not at issue, will survive indefinitely.
Subsequent to the closing of the transaction, Western Filter discovered that Puroflow’s
inventory was allegedly worth “significantly less” than what Argan represented and that
Puroflow and Argan grossly misrepresented the financial condition of Puroflow. After the
one year period specified in the purchase agreement, Western Filter made a claim under
the purchase agreement and sued Argan and its officers for breach of contract, intentional
misrepresentation, concealment and nondisclosure, negligent misrepresentation, false
promise, negligence, and declaratory relief claiming damages in excess of $2 million. The
district court granted Argan’s motion for summary judgment and concluded that Western
Filter’s claims were barred by the one-year limitation set forth in the survival clause. The
district court concluded that the plain meaning of the survival clause clearly indicated that
if Argan breached “certain representations and warranties, then for a period of one-year
after the closing, Western Filter could file a claim” against Argan for breach, but more than
one year had passed.
Corporate, Mergers & Acquisitions, and Securities Alert
Ninth Circuit
Upon appeal, the Ninth Circuit reversed the summary
judgment entered by the district court “because the
language of the survival clause is ambiguous.” In
doing so, the Court noted that California law permits
parties to a contract to stipulate therein for a period
of limitation, shorter than that fixed by the statute
of limitations, and that such stipulation violates no
principle of public policy, provided that the period fixed
be not so unreasonable as to show imposition or due
advantage in some way. However, while allowed under
California law, contractual stipulations are not favored
and should be “construed with strictness” because they
are in derogation of the statutory limitation.
The Ninth Circuit concluded that the one-year limitation
in the survival clause serves “only to specify when a
breach of representation and warranties may occur,
but not when an action must be filed.” As a result, the
Court concluded that since the SPA did not clearly
limit the right to file a claim to a period shorter than
that granted by the statute, Western Filter timely filed
its claim within the California statute of limitations
even though not within the one-year limitation in the
survival clause.
Reducing the Statute of Limitations
under California Law
In our view, the Ninth Circuit’s decision does not
reflect a clear understanding of how representations
and warranties and negotiated limitations of time to
bring claims function. The Court rests its decision
on its claim that if a representation “survives” the
closing of a transaction, a party can sue for a breach
that occurs after closing. The Court failed to note that
the representations and warranties in a typical purchase
agreement speak as to specific times (typically, the
date of the purchase agreement, or in some cases also
on the closing date), and therefore any breach, while
perhaps discovered after the closing, must necessarily
have actually occurred at or prior to the closing.
“Survival,” as a concept, has always been understood
to relate to the discovery of a breach and the ability
to bring claims for such a breach, not the timing of
a breach. Otherwise, the concept of a representation
speaking as to a specific time, as expressly drafted by
the parties, would automatically become a promise of
future performance post-closing—a concept that is
alien to virtually all acquisitions of businesses. While
the discovery of a breach of a representation can occur
after the closing, the breach itself must have occurred
at or prior to the closing. The Court’s entire analysis
assumed that the breach, not merely the discovery of
the breach, could happen post-closing. Without that
assumption, there would have been no “ambiguity” that
the Court used to eviscerate the one year contractual
limitation on the availability of recovery.
Only time will tell if the Ninth Circuit’s decision
will be upheld, but for now, contracting parties
should proceed with caution when entering into an
acquisition agreement governed by California law. In
accordance with Western Filter, contracting parties
desiring to limit the period of time to file a claim
should draft the language in the acquisition agreement
to unambiguously state (i) that it is the parties intent
to limit the period of time a claim may be filed, even
if that period is shorter than that fixed by the statute
of limitations; (ii) that representation and warranties
terminate at the end of the survival period; and (iii) any
and all claims resulting from the acquisition agreement
shall be filed by the end of the survival period.
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