Submitted: July 24, 2013
Larry R. Wood, Jr., Esq., Alisa E. Moen, Esq., Elizabeth A. Sloan, Esq., BLANK ROME LLP, Wilmington, Delaware; Michael A. Iannucci, Esq., BLANK ROME LLP, Philadelphia, Pennsylvania; Attorneys for Plaintiff.
John L. Reed, Esq., Scott B. Czerwonka, Esq., Andrew H. Sauder, Esq., DLA PIPER LLP, Wilmington, Delaware; Hugh J. Marbury, Esq., Benjamin D. Schuman, DLA PIPER LLP, Baltimore, Maryland; Attorneys for Defendants.
PARSONS, Vice Chancellor J.
In this action, the buyer under an agreement to purchase the remaining capital stock of a company brings breach of contract and fraud claims against the sellers. The buyer alleges that the sellers manipulated the financial condition of the company in the periods leading up to the execution and the closing of the agreement to make the company appear to be more successful than it actually was. The buyer also claims that, before the closing, the sellers discovered that the company significantly had underperformed compared to its forecasts in the most recent financial quarter, but concealed this fact from the buyer. In its complaint, the buyer asserts, among other things, claims for breach of contract, breach of warranty, breach of the implied covenant of good faith and fair dealing, and fraud. As remedies for the alleged misconduct of the sellers, the buyer requests indemnification, damages, and a declaratory judgment in its favor.
The defendants have moved to dismiss the complaint under Court of Chancery Rule 12(b)(6) for failure to state a claim. This Memorandum Opinion reflects my ruling on the defendants' motion. For the reasons that follow, I grant the motion in part and deny it in part. Specifically, I grant the defendants' motion to dismiss the buyer's claims for breach of warranty, equitable fraud, and breach of the implied covenant. I deny the defendants' motion in all other respects.
A. The Parties
The plaintiff in this action is Osram Sylvania Inc. ("OSI" or "Plaintiff”). The defendants are Townsend Ventures LLC, TV Encelium Investment I, Inc., TV Encelium Investment II, Inc., Anthony Marano, Terry Mocherniak, and Marc Hoffknecht (collectively, "Sellers" or "Defendants"). All of the business entities that are parties to this lawsuit were organized under the laws of Delaware.
1. Relevant background
OSI and Sellers are parties to a contested Stock Purchase Agreement ("SPA"), pursuant to which OSI purchased from Sellers all of the remaining issued and outstanding stock of Encelium Holdings, Inc., a Delaware corporation ("Encelium" or the "Company"). Encelium operates its business through a subsidiary, Encelium Technologies ULC, a British Columbia unlimited liability company ("Encelium Technologies").
In 2011, OSI owned, indirectly through an affiliate, certain Purchaser Preferred Stock in Encelium. Sometime in 2011, OSI and Sellers began to discuss the possibility of OSI purchasing the remaining stock of the Company. On or about May 25, 2011, Sellers provided OSI with a presentation about Encelium (the "Management Presentation") that included information about its technology, its sales and financials, the market in which it operates, the competitive landscape, and a review of Encelium's operations.
In the Management Presentation, Sellers informed OSI that Encelium was planning to release products based on its newly developed GreenBus II technology (a successor to GreenBus I) in Fourth Quarter 2011. The Management Presentation revealed that Encelium had a negative EBITDA for calendar year 2010, but was projecting sales for calendar year 2011 of approximately $18 million. Sellers also informed OSI that two of Encelium's employees, Lisa Scholl and Neil Schroder, together were responsible for approximately 32% of the forecasted sales for 2011.
Following the Management Presentation, OSI and Sellers had numerous discussions about Sellers' sales forecasts, and Sellers knew that it was important to OSI that Encelium achieve its sales forecasts for Second and Third Quarter 2011. According to OSI, Sellers understood that the 2011 forecast numbers were integral to OSI's calculation of the purchase price for Encelium.
In early July 2011, Sellers reported to OSI that Encelium's sales for Second Quarter 2011 (which ended on June 30, 2011) were consistent with the forecasted sales numbers. For Third Quarter 2011, Sellers forecasted sales of approximately $4 million. Based on Sellers' representations concerning the financial condition, operating results, income, revenue, and expenses of Encelium, OSI agreed to pay approximately $47 million, subject to certain adjustments, for the Company's remaining capital stock. To that end, the parties executed the SPA (the "Execution") on September 30, 2011 (the "Effective Date"), the last day of Third Quarter 2011. The transaction closed (the "Closing") on October 14, 2011 (the "Closing Date").
2. OSI's allegations
After the Closing, OSI learned that Encelium's sales in Third Quarter 2011 were significantly less than Sellers had forecasted. Encelium's Third Quarter sales were only $2 million, or approximately one half of the sales the Company had forecasted for that period. OSI alleges that Sellers knew Encelium's actual sales results for Third Quarter 2011 by the Closing Date, but they did not inform OSI of the Company's underperformance.
Upon further investigation, OSI alleges it discovered that Sellers had manipulated the Second Quarter 2011 numbers to hide the fact that the business of Encelium was not as Sellers had represented. OSI contends that, beginning in Second Quarter 2011 and continuing until the Closing, Sellers manipulated the financial condition and working capital of Encelium by, among other things: holding invoices for payment, billing and shipping excess product to create reportable revenue (without disclosing the credits to be applied), and failing to disclose discount policies. According to OSI, Sellers also attempted to manipulate the financial condition of the Company by altering the size and nature of the Company's business segments before the Closing. OSI asserts that, for all these reasons, the information in the Financial Statements, including those through June 30, 2011, did not fairly present the financial condition and results of operations of Encelium and, further, was not consistent with GAAP.
OSI also alleges that Sellers knew, by the Closing Date, that Encelium's salespeople Scholl and Schroder had resigned, but they did not notify OSI of this fact before the Closing. Together, Scholl and Schroder accounted for approximately 32% of Encelium's 2011 sales forecast. Scholl had been expected to make nearly $3.4 million in sales in the Third and Fourth Quarters of 2011. She resigned in mid-June 2011, however, before the end of the Second Quarter. Schroder had been expected to make $3.3 million in sales in 2011, but he resigned before August 2011.
OSI further contends that, as of the Closing Date, Sellers were aware that Encelium had a significant liability that it had not accounted for in its financial statements or otherwise disclosed to OSI. Specifically, as of March 2011, Encelium had accepted a purchase order requiring it to provide and install lighting control systems in sixteen buildings at Patrick Air Force Base ("PAFB") (the "PAFB Contract"). The PAFB Contract required that these systems be able to "utilize and interface with the LonTalk protocol in communication." As of the Closing Date, however, the Encelium Lighting Control System had never interfaced with LonTalk. OSI asserts, therefore, that Encelium had a significant and costly obligation to make its Lighting Control System compatible with LonTalk, but that Sellers did not disclose properly or otherwise account for that obligation.
In addition, OSI claims that Sellers had represented to it that Encelium maintained about $400, 000 worth of inventory of product based on the Company's GreenBus I technology. Yet, notwithstanding the anticipated launch of GreenBus II, Encelium's inventory of GreenBus I based technology had grown to nearly $1 million by the Closing.
As evidence of Sellers' bad faith in their alleged manipulation and concealment of Encelium's financial information, OSI refers to an August 2011 internal email by one of the Sellers. That email states that "[g]iven where sales are going the distraction with senior management is far too great to keep up any charade on the chance that a deal does happen." OSI argues that this email supports an inference that Sellers were putting on a "charade" in order to entice OSI to enter into the SPA. OSI also avers that, in October, immediately before the Closing, Sellers stated in internal communications that if the Closing did not occur soon, the Company would have a "cash problem." According to OSI, Sellers discussed addressing this issue by buying product from Encelium, which OSI avers provides further proof that Sellers attempted to prop up falsely the revenue and operations of Encelium before the Closing.
Based on the foregoing allegations, OSI contends that Sellers have breached numerous provisions of the SPA as well as the implied covenant of good faith and fair dealing. OSI also asserts several fraud-related claims arising from Sellers' alleged manipulation and concealment of Encelium's financial information in the periods before the Effective Date and the Closing. Due to Sellers' misconduct, OSI avers that it paid significantly more than it otherwise would have for the Company and requests, among other relief, damages and indemnification for its losses.
3. Relevant provisions of the SPA
The SPA contains numerous provisions that are relevant to this action. They generally fall into three categories: (1) representations and warranties; (2) covenants; and (3) indemnification. Article 3 of the SPA, entitled "Representations and Warranties Relating to the Acquired Companies, " contains many of the provisions that OSI relies on in bringing its claims. For purposes of the contract, "Acquired Companies" is defined to include Encelium and its subsidiaries, such as Encelium Technologies.
Section 3.5(b) of the SPA is a warranty of the accuracy of Encelium's financial statements from 2008 through June 30, 2011 (the end of Second Quarter 2011). It provides that: "[t]he Financial Statements are correct and complete in all material respects . . . and fairly present the financial condition and the results of operations, changes in shareholders' equity, and cash flows of the Acquired Companies . . . all in accordance with GAAP consistently applied."
Section 3.5(c) is a warranty that the Company has been operated in the ordinary course of business and that no material adverse changes have occurred. It provides that: "[s]ince the date of the Interim Balance Sheet [June 30, 2011], the Acquired Companies have operated the Business in the ordinary course of the Acquired Companies' Business consistent with past custom and practice." It further warrants that "there has not occurred any event or development that has resulted in, or would reasonably be expected to result in, a Material Adverse Change."
Section 3.6 is a warranty as to liabilities. It provides that the Acquired Companies have not incurred any liabilities, except for liabilities: "(i) accrued or reserved against on the Interim Balance Sheet (which reserves are adequate, appropriate and reasonable); (ii) incurred in the Ordinary Course of Business of the Company since the date of the Interim Balance Sheet . . . or (iii) set forth on Schedule 3.6 of the Disclosure Schedules." That section also warrants that any liabilities incurred in the ordinary course do not "individually or in the aggregate . . . have a Material Adverse Effect on the Business."
Section 3.7 provides that for the period since December 31, 2010, similarly to Section 3.5(c), "no change or event . . . has resulted in, or would reasonably be expected to result in, a Material Adverse Effect." Section 3.20 states that the inventory of the Acquired Companies is accurately disclosed and is "of a quantity, quality and mix as are historically consistent with past business practices." Finally, Section 3.35 provides that: "[n]o representation or warranty by any of the Seller Parties contained in this Agreement or any Transactional Document contains any untrue statements of material fact or intentionally omits to state any material fact necessary to make the statements . . . not misleading."
In its breach of contract claims, OSI also invokes the covenants contained in Sections 6.1 and 6.4 of the SPA. Section 6.1 requires Sellers to operate the Company in the ordinary course of business between the Effective Date (September 30, 2011) and the Closing Date (October 14, 2011). Section 6.4 requires Sellers, in that same period, to notify OSI of any fact or circumstance that: "(i) has had, or would reasonably be expected to have, individually or in the aggregate, a Material Adverse Effect; [or] (ii) has resulted in, or could reasonably be expected to result in, any representation, warranty, covenant, condition, or agreement made by such Seller not being true or correct."
Based on Sellers' alleged breaches of the preceding provisions, OSI seeks indemnification. In Section 9.2(a)(i) and 9.2(a)(ii), Sellers agreed to "indemnify, defend, protect and hold harmless" OSI and its affiliates from "all losses and damages, including reasonable attorneys' fees, resulting from, imposed upon, or incurred or suffered by [OSI], directly or indirectly, as a result of" breaches of the SPA by Sellers or the Acquired Companies. Specifically, the SPA provides for indemnification of OSI for losses or damages caused by "a breach or non-fulfillment [of] . . . a covenant or obligation in this Agreement or in any Transaction Document" by a Seller,  or by an Acquired Company prior to the Closing. In addition, Sellers agreed to indemnify OSI for any losses or damages resulting from: "a breach of or inaccuracy in a representation or warranty made by [Sellers] in Article 3 . . . without giving effect to any qualifications as to 'materiality, ' 'Material Adverse Effect, ' or similar words."
Section 9.3(a) establishes an indemnification threshold. It provides that Sellers will not have to indemnify OSI for inaccuracies in the representations and warranties contained in Article 3 unless the aggregate amount of indemnifiable damages attributable to those inaccuracies exceeds $200, 000, in which case Sellers will be liable for the full amount. For the stated purpose of avoiding disputes over the meaning of materiality qualifiers in calculating indemnifiable damages, Section 9.4, like Section 9.2(a)(i)(A), includes a "materiality scrape." Section 9.4 specifies that, "for purposes of this Article 9, any . . . materiality qualifier contained in any representation or warranty shall be ignored in determining whether there has been a breach of or inaccuracy in a representation or warranty and in measuring the corresponding damages." The scope of the Section 9.4 "materiality scrape" explicitly includes terms such as "'Material Adverse Effect, ' 'material, ' 'materially, ' 'in all material respects' or similar materiality qualifiers."
C. Procedural History
On December 19, 2012, OSI filed its Verified Complaint (the "Complaint") against Defendants, the Sellers under the SPA. The Complaint states eight counts against Defendants for breach of contract (Count I), breach of warranty (Count II), indemnification (Count III), equitable fraud (Count IV), fraud (Count V), negligent misrepresentation (Count VI), breach of the covenant of good faith and fair dealing (Count VII), and declaratory judgment (Count VIII). Sellers filed a motion to dismiss the entire Complaint (the "Motion to Dismiss" or "Motion") on March 1, 2013. After full briefing, I heard argument on that motion on July 12, 2013. Following argument, the parties each submitted supplemental briefing on the Delaware Supreme Court's opinion in Gerber v. Enterprise Products Holdings, LLC,  and its possible application to OSI's claim for breach of the implied covenant of good faith and fair dealing.
D. Parties' Contentions
Sellers assert that OSI's claims are duplicative and fit into two main categories: (1) claims arising out of the SPA; and (2) claims sounding in fraud. In seeking dismissal of the Complaint, Sellers argue that OSI has failed to state a valid claim for breach of the SPA or for fraud. Defendants contend that each of OSI's contract-based claims fails because OSI has not sufficiently tied any alleged misconduct by Sellers to specific provisions of the SPA. As to OSI's fraud-based claims, Defendants maintain that none of them is pled with particularity as required by ...