Osram Sylvania Inc. v. Townsend Ventures, LLC, C.A. No. 8123-VCP (Del. Ch. Nov. 19, 2013) (Parsons, V.C.)
In this decision, the Court of Chancery held that the buyer under a stock purchase agreement had stated claims for breach of contract, fraud, and negligent misrepresentation by alleging that the selling stockholders manipulated and concealed the financial and operational condition of the subject company. Notably, the Court concluded that it was reasonably conceivable that financial manipulation that occurred before the agreement was executed and the company’s failure to meet quarterly sales forecasts could result in a Material Adverse Effect under the agreement.
In early 2011, plaintiff Osram Sylvania Inc. began discussions with stockholders of Encelium Holdings, Inc. regarding a purchase of the Encelium stock that Osram did not already own. In July 2011, Encelium’s stockholders (the “Sellers”) informed Osram that Encelium had met its second quarter 2011 sales forecasts and that the Sellers forecasted sales of approximately $4 million for the third quarter of 2011. On September 30, 2011, the parties entered into a stock purchase agreement (the “Agreement”) pursuant to which Osram would pay $47 million for all of the Encelium stock it did not already own.
After the sale closed, Osram discovered that Encelium’s third quarter sales were approximately $2 million, half of what the Sellers had forecasted. Osram brought an action in the Court of Chancery seeking indemnification under the Agreement based on allegations that the Sellers had manipulated and concealed Encelium’s financial and operational condition by, for example, holding invoices for payment, shipping excess product to create reportable revenue, and altering the size and nature of Encelium’s business segments. Osram also alleged that the Sellers knew by the closing date that two of Encelium’s salespeople, who together accounted for approximately 32% of Encelium’s 2011 sales forecast, had left Encelium before the Agreement was signed. Osram further alleged that, as of closing, the Sellers were aware that Encelium had a significant liability in connection with a lighting installation contract that was not disclosed to Osram or accounted for in Encelium’s financial statements. Finally, Osram alleged that Encelium had grown its inventory of one product line to more than twice the amount the Sellers represented that it would maintain.
Based on these allegations, Osram brought claims for (i) breach of the Agreement, (ii) fraud, equitable fraud, and negligent misrepresentation, and (iii) breach of the implied covenant of good faith and fair dealing. The Sellers moved to dismiss for failure to state a claim under Court of Chancery Rule 12(b)(6).
As to the breach of contract claims, the Court found that Osram, through its allegations of financial manipulation and misrepresentation by the Sellers, stated claims for breach of four warranty provisions of the Agreement: Section 3.5(b) (warranty of the accuracy of Encelium’s financial statements through June 30, 2011), Section 3.5(c) (warranty that Encelium has been operated in the ordinary course of business and that no Material Adverse Changes have occurred), Section 3.7 (warranty that there has not been an event that has resulted in, or would reasonably be expected to result in, a Material Adverse Effect), and Section 3.35 (warranty that the Sellers’ other representations and warranties are true and complete). Notably, the Court found that it was “reasonably conceivable” that the Sellers’ alleged pre-signingfinancial manipulation could result in a Material Adverse Effect on Encelium if, for example, excess product was returned or the restructuring of Encelium’s business segments threatened its long-term viability. Based on allegations of similar conduct post-signing, as well as the allegation that the Sellers knew that the third quarter 2011 sales were only half of what had been forecast, the Court concluded that Osram had stated a claim for breach of Sections 6.1 and 6.4 of the Agreement, which required the Sellers to (i) operate Encelium in the ordinary course of business between signing and closing and (ii) inform Osram of any event during that period that could reasonably be expected to have a Material Adverse Effect. The Court held that the drop in third quarter revenue, which was not disclosed to Osram before closing, reasonably could be interpreted as having a Material Adverse Effect on Encelium.
The Court next held that Osram had stated a claim based on the theory that the departure of two key salespeople in 2011 constituted a Material Adverse Effect that was not adequately disclosed. First, the Court held that the carve-out from the definitions of Material Adverse Effect and Material Adverse Change for an event resulting from “general business or economic conditions” would likely apply only if it was later demonstrated that the employee departures were related to “some larger economic trend.” Second, the Court held that if the loss of these employees was reasonably expected to result in a Material Adverse Change, the Sellers may have been required to “affirmatively” disclose that event, leaving open the possibility that merely failing to list the employees on the schedule of current employees that was part of the Agreement, as the Sellers had done, was not sufficient.
Osram alleged that the Sellers violated two additional provisions of the Agreement. Section 3.6 was a warranty that Encelium had not incurred any liabilities other than those (i) incurred in the ordinary course of business after June 30, 2011, (ii) accrued or reserved on an interim balance sheet, or (iii) set forth in the Agreement’s disclosure schedules. The Court held that Osram stated a claim for breach of this provision based on the allegation that in March 2011 Encelium incurred a liability in connection with a lighting installation contract that was not accounted for in its financial statements or set forth in the Agreement’s disclosure schedules. Section 3.20 was a warranty that Encelium’s inventory was consistent with past practices. The Court held that Osram had stated a claim for breach of this provision based on the allegation that Encelium’s inventory of a certain product class had more than doubled from past practice as of the closing.
As to Osram’s fraud-based claims, the Court held that the allegations of intentional financial manipulation and misrepresentation supported claims for fraud and negligent misrepresentation against the Sellers. The Court dismissed Osram’s claim for equitable fraud based on the absence of any allegation of a fiduciary or other special relationship of trust or confidence between Osram and the Sellers, which is a necessary element of such a claim. The Court also dismissed Osram’s claim for breach of the implied covenant of good faith and fair dealing, holding that nearly all of the alleged misconduct was governed by the express provisions of the Agreement, and that the parties could have anticipated Encelium’s failure to achieve sales forecasts, leaving no room for a claim based on the implied covenant.