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Narrowstep, Inc. v. Onstream Media Corporation, C.A. No. 5114-VCP (Del. Ch. Dec. 22, 2010) (Parsons, V.C.)

December 21, 2010

In this opinion the Court of Chancery dismissed a claim for breach of the implied covenant of good faith and fair dealing, but declined to dismiss claims of breach of contract, unjust enrichment and fraudulent inducement in connection with the failed merger of Onstream Media Corporation (“Onstream”) and Narrowstep, Inc. (“Narrowstep”), two internet TV service providers.

The claims arose out of a May 29, 2008 merger agreement pursuant to which Narrowstep ceded operational control to Onstream and began executing an integration plan that left it unable to operate independently well before the merger was to close. As a result, Narrowstep was defenseless against Onstream’s demands for two amendments to the merger agreement and was forced to make many concessions, including time extensions and merger price reductions. When Narrowstep refused Onstream’s efforts to negotiate a third amendment with a further price reduction, Onstream purported to terminate. Narrowstep then sued Onstream alleging breach of contract, breach of the implied covenant of good faith and fair dealing, fraud, unjust enrichment and conversion. Defendants moved to dismiss all but the conversion claim.

In refusing to dismiss all but the claim for breach of the implied covenant of good faith and fair dealing, the Court applied the standard recently articulated by the U.S. Supreme Court in Bell Atlantic v. Twombly, that the complaint must offer “sufficient facts to plausibly suggest that the plaintiff will ultimately be entitled to the relief she seeks.” The Court took judicial notice of the merger agreement and the two amendments the agreement, explaining that they were integral to and incorporated in the complaint. The Court declined to take judicial notice of SEC filings, however, because they were submitted to establish disputed facts about Narrowstep’s financial condition prior to the merger agreement.

In refusing to dismiss the breach of contract claims, the Court noted that, before entering the merger agreement, Onstream conducted six months of due diligence during which it had direct access to Narrowstep customers. Thus, it was plausible that Onstream’s later excuses about lost customers, delinquent payments and various tax issues were manufactured as part of an intentional scheme to string along Narrowstep with no intention of closing, but to pilfer its assets while the early integration process left it defenseless and made it costlier to unwind the transaction than to agree to price reductions. Accordingly, the Court found that the allegations supported the claims that Onstream failed to exercise “reasonable best efforts to cause the Registration Statement to be filed” or to consummate the merger, and that Onstream could not validly terminate the agreement because of its own failure to perform its obligations in breach of the merger agreement. Narrowstep’s detailed allegations of millions of dollars in lost revenue, lost customers and lost ability to operate as an independent company were adequate to show damages.

In dismissing the implied covenant of good faith and fair dealing claim, the Court noted that such claims are rarely invoked successfully because a covenant is only implied by the Court when the current dispute is not addressed by the express terms of the contract but, at the same time, it is clear from the express terms that the parties would have agreed to proscribe an act if they had thought to negotiate it. Narrowstep sought to have the Court imply a deadline for consummation and find that Onstream’s breached the implied deadline with its bad faith delays. The Court refused to imply a deadline, finding that the express terms of the agreement addressed closing. First, the agreement required closing to take place within two business days of satisfaction of all conditions. Second, the agreement provided a final date by which the merger agreement would terminate if not consummated. Similarly, the Court rejected the argument that Onstream’s bad faith delay breached an implied covenant, because the reasonable best efforts provisions in the merger agreement expressly addressed Onstream’s delay and the Court will not invoke the implied covenant to override the express provisions of a contract.

In refusing to dismiss the fraud claims that Onstream had no intention of merging when it entered the Merger Agreement, the Court held that the complaint alleged all five elements of common law fraud as well as a fiduciary relationship sufficient to support equitable fraud. The complaint alleged that Onstream made several representations that it desired to close a merger expeditiously, with knowledge of their falsity and with intent to induce Narrowstep to act or refrain from acting as part of a scheme to misappropriate Narrowstep’s assets. The fraud included the stringent conditions in the merger agreement that enabled Onstream to strip its competitor of the ability to continue as an independent company, and continued during the integration period when Onstream manufactured excuses to delay closing and extract price reductions while plundering Narrowstep’s assets. Importantly, the Court also found that Narrowstep reasonably relied on Onstream’s continuous reassurances.

Because the complaint met the requirements for common law fraud, it was also deemed sufficient to plead the broader claim of equitable fraud, which does not require scienter. Instead, equitable fraud requires a special relationship between the parties or other special equities, such as a fiduciary relationship. Noting that the Court is reluctant to extend fiduciary duties to commercial relationships, the Court nonetheless held that Onstream dominated and controlled Narrowstep while the parties’ interests in expeditious closing were purportedly aligned, thus it owed Narrowstep fiduciary duties. Onstream argued that Narrowstep was merely bootstrapping its fraud claim to its breach of contract claim by alleging that Onstream never intended to perform its obligations, but the Court held that the allegations that Onstream repeatedly lied to string Narrowstep along with no intention of closing goes beyond a mere intention not to comply with the terms of the agreement.

Finally, the Court refused to dismiss unjust enrichment as an alternate theory of recovery, finding sufficient facts to demonstrate that Onstream impermissibly and unjustifiably obtained, used, or sold Narrowstep’s equipment and proprietary information causing direct harm. Further, issues of fact existed regarding rights to use confidential information and to sell and retain proceeds for specific pieces of equipment, such that the merger agreement may not comprehensively govern the parties’ relationship.

The full opinion is available here