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Sparton Corp. v. O'Neil

Court of Chancery of Delaware

August 9, 2017

SPARTON CORPORATION, an Ohio Corporation, Plaintiff,
v.
JOSEPH F. O'NEIL, PETER DUMANIAN, TODD MOUTAFIAN, JASON LEVY, JASON SEIFERT, THOMAS J. YORKEY, WALTER E. GORDON, THOMAS W. PARKER, MARK EVANS, CARMEN GONZALEZ, HAI CAO NGUYEN, BILLY CHEN, HASSAN MALAK, PHILIP J. AGUIAR, THUY THANH THI NGUYEN, CHERYL MARIE PITTMAN-LEWIS, DANIEL T. JACKSON, JOSEPH R. WEEMS, GREGORY A. EDGMON, RICHARD N.C. MICAEL, BEN MCDERMOTT, TY VAN LE, SCOTT A. ZELGEWICZ, JOSEPH P. LOEFFLER, CHRISTOPHER J. ALESSIO, AND IAN GROVER, Defendants. JOSEPH F. O'NEIL, in his capacity as Representative of the former Stockholders and Optionholders of Hunter Technology Corporation, Counterplaintiff,
v.
SPARTON CORPORATION, Counterdefendant.

          Date Submitted: June 6, 2017

          Richard M. Beck and Sean M. Brennecke, KLEHR HARRISON HARVEY BRANZBURG LLP, Wilmington, Delaware; Joseph J. Shannon, BODMAN PLC, Detroit, Michigan; Attorneys for Plaintiff.

          William M. Lafferty, John P. DiTomo, and Zi-Xiang Shen, MORRIS, NICHOLS, ARSHT & TUNNELL LLP, Wilmington, Delaware; Mark A. Schwartz and Sandra J. Durkin, BUTLER RUBIN SALTARELLI & BOYD LLP, Chicago, Illinois; Attorneys for Defendants.

          MEMORANDUM OPINION

          MONTGOMERY-REEVES, Vice Chancellor.

         This action involves a merger in which Sparton Corporation ("Sparton"), the purchaser, alleges that the merger agreement was fraudulently induced. Sparton argues that Joseph F. O'Neil, the representative of the stockholders and option holders of Hunter Technology Corporation ("Hunter"), the seller, with the assistance of the other defendants, created and presented false financial statements during the negotiations. Based on these fabricated financials, the parties agreed to a pre-closing estimate of Hunter's working capital, an escrow amount, and a cap on the post-closing adjustment of working capital. Prior to the closing, without Sparton's knowledge, the defendants allegedly wrote down the accounts receivable, returning Hunter's working capital to its correct lower value. After the transaction, Sparton discovered that the working capital actually was much lower than originally thought, and the agreed-upon escrow amount was inadequate to cover the difference. Sparton argues that defendants' fraudulent actions caused millions in damages.

         Sparton also asserts a breach of contract claim against the stockholders and option holders of Hunter, alleging that Hunter's financial statements and accounts receivable did not accurately represent its working capital in breach of the warranties contained in the merger agreement (the "Working Capital Claim"). Additionally, Sparton asserts that O'Neil failed to use commercially reasonable efforts to resolve certain liabilities that Hunter incurred before the transaction in breach of the merger agreement (the "Specific Indemnity Claims"), and the defendants incurred but failed to pay certain invoices, as required under the agreement (the "Expenses Claim"). As a result of the purported fraud and contractual breaches, Sparton alleges it has suffered (1) $1, 829, 455.00 in damages representing the difference between the inflated working capital it paid for and the working capital that actually existed at closing; (2) unliquidated damages in the amount of fees and costs necessary to resolve the liabilities that O'Neil promised to resolve; and (3) $100, 498.70 in damages for the invoices incurred by Hunter for which Sparton now is responsible.

         The defendants move to dismiss all claims except the Expenses Claim. The defendants argue that the merger agreement bars both breach of contract claims because the agreement provides exclusive remedies for the purported breaches. Additionally, the defendants contend that Sparton has failed to state a claim for the Specific Indemnity Claims. As to the Working Capital Claim, the agreement's exclusive remedy provision provides a fraud exception; but, the defendants argue that (1) the agreement contains an anti-reliance provision; (2) the defendants did not make any representations to Sparton in the contract regarding the veracity of the financial statements that could form the basis for the fraud claim; and (3) Sparton fails to meet the heightened pleading standard required to state a claim for fraud. For the reasons discussed below, I find that the agreement bars both breach of contract claims and that Sparton has failed to state a claim for fraud. Therefore, the motion to dismiss is granted in its entirety.

         I. BACKGROUND

         All facts are drawn from the First Amended Verified Complaint (the "Complaint") and the documents incorporated by reference therein.[1]

         A. Parties and Relevant Non Parties

         Plaintiff Sparton Corporation ("Sparton") is a company incorporated in Ohio with its principal place of business in Schaumberg, Illinois. Non-party Hunter Technology Corporation ("Hunter" or the "Company") is a California corporation. Non-party Sparton Hunter Corporation ("Merger Sub") was Sparton's subsidiary formed to effectuate the merger between Hunter and Sparton, with Hunter as the surviving wholly-owned subsidiary of Sparton.

         Defendants Joseph F. O'Neil, Peter Dumanian, Todd Moutafian, Jason Levy, and Jason Seifert were stockholders of Hunter before the transaction (collectively, the "Stockholders"). Defendants Thomas J. Yorkey, Walter E. Gordon, Thomas W. Parker, Mark Evans, Carmen Gonzalez, Hai Cao Nguyen, Billy Chen, Hassan Malak, Philip J. Aguiar, Thuy Thanh Thi Nguyen, Cheryl Marie Pittman-Lewis, Daniel T. Jackson, Joseph R. Weems, Gregory A. Edgmon, Richard N.C. Micael, Ben McDermott, Ty Van Le, Scott A. Zelgewicz, Joseph P. Loeffler, Christopher J. Alessio, and Ian Grover were optionholders of Hunter before the transaction (collectively, the "Optionholders").

         B. Facts

         On April 14, 2015, Sparton, Hunter, Merger Sub, and O'Neil executed a merger agreement through which Sparton acquired Hunter (the "Agreement"). O'Neil negotiated and executed the Agreement as the "representative, agent, proxy, and attorney in fact (coupled with an interest) for all the Stockholders and Optionholders for all purposes under this Agreement . . . ."[2] As a result of the transaction, the Stockholders and Optionholders received $55, 000, 000.00 in exchange for the cancellation of their shares and outstanding options. The resolution of the pending motion to dismiss requires an examination of certain contractual provisions of the Agreement and, in some instances, the negotiations surrounding those provisions.

         1. The representations and warranties

         Hunter provided the following representations and warranties in Article V of the Agreement:

The Financial Statements have been based upon the information contained in the Company's and its Subsidiaries' books and records (which are true and complete in all material respects, have been maintained consistently with past practices, and have been made available for inspection by Purchaser or its representatives), have been prepared in conformity with GAAP, and present fairly in all material respects the financial condition and results of operations of the Company and its Subsidiaries as of the times and for the periods referred to therein. . . .[3]
Except as set forth on the Developments Schedule, since September 30, 2014, there has not been any Material Adverse Change.[4]

         Thus, the Company represented that the financial statements were based on the Company's books and records (which were accurate), prepared in accordance with GAAP principles, and "present[ed] fairly in all material respects the financial condition and results of operations of the Company."[5]

         The Optionholders and Stockholders agreed to indemnify Sparton for any losses incurred as a result of "any breach of, or any misrepresentation with respect to, any of the representations and warranties expressly and specifically set forth in Article V."[6] Article V includes the Company's representation regarding the financial statements' accuracy. But the indemnification provision precludes recovery for any loss "included in the calculation of the final Allocable Amount, " except in the case of fraud.[7] The "Allocable Amount" includes a calculation to adjust for changes to the Company's working capital.[8]

         2. The working capital

         To account for Hunter's working capital variation over time, the parties agreed that they would use a pre-closing estimate of working capital based on Hunter's March 31, 2015 financial statements and a post-closing working capital adjustment. Section 3.03 of the Agreement provides that at least three business days before closing, "the Company shall prepare and deliver to the Purchaser a good faith estimate of the Allocable Amount based on the Company's books and records and other information then available."[9] As discussed above, working capital is included in the calculation of the Allocable Amount.[10] If within five business days after the final Allocable Amount is determined, the actual Allocable Amount is less than the estimate, then the escrow agent will pay Sparton the amount of the deficiency from the Purchase Price Adjustment Escrow Funds. Any such payments "shall be the sole and exclusive remedy of the Purchaser for any and all claims arising under this Agreement with respect to this Section 3.03."[11] Section 13.14(b) echoes Section 3.03, adding that Sparton "agrees and acknowledges that its right to any payment made pursuant to Section 3.03(h)(i) . . . shall be the Purchaser's sole and exclusive source of recovery for any amounts owing to the Purchaser pursuant to Section 3.03(h)(i), except for claims for Fraud."[12]

         On April 10, 2015, Hunter, Sparton, and the Stockholders agreed to the pre-closing estimate of working capital. Based on this estimate and "O'Neil's representation that any resulting post-closing working capital adjustment would be minimal, and at Defendant O'Neil's insistence, "[13] the parties agreed that the working capital adjustment was capped at $750, 000.00 and was the exclusive remedy for any overstatement of the working capital, except in the case of fraud.

         Sparton alleges that before the working capital estimate was calculated, O'Neil, with assistance from Alessio, Nguyen, Edgmon, Evans, "and others, made non-GAAP adjustments to Hunter's accounts receivable, thereby artificially overstating the value of Hunter's accounts."[14] This included "adding amounts to invoices that were not owed to Hunter, including invoicing customers for work that Hunter had not yet completed and for which it did not yet have the right to payment, and invoicing for obsolete inventory where Hunter had no right or expectation of payment."[15] Sparton contends that between April 10 and April 13, after Sparton had accepted the working capital estimate and agreed to the $750, 000.00 escrow amount and cap, but before closing, "Defendants O'Neil, Alessio, Nguyen, Edgmon, Evans, and others purposefully caused Hunter to write off the overstated invoices, reverting Hunter's working capital to its actual, lower value."[16] Sparton alleges that "[m]any of these adjustments were made on Sunday April 12, 2015."[17] Sparton asserts that as a result of this conduct, "Sparton overpaid for Hunter's working capital by $2, 579, 455.00."[18]

         Sparton presented O'Neil with its post-closing working capital adjustment of $2, 579, 455.00, and O'Neil did not dispute the amount but rather released the entire $750, 00.00 working capital escrow amount to Sparton. Sparton then requested an additional $550, 000.00 from the indemnity escrow fund to mitigate its working capital damages. O'Neil objected to this request, and the indemnity escrow funds have not been released.

         3. The specific indemnity schedule

         As part of the Agreement, O'Neil would "have responsibility for managing, handling and controlling the defense, settlement or other disposition of the matters set forth" in the Specific Indemnity Schedule. O'Neil was obligated to "use commercially reasonable efforts to settle on commercially reasonable terms the matters set forth on this Specific Indemnity Schedule within 18 months of the Closing Date."[19] O'Neil also was to "provide Purchaser with information regarding the process of such settlements upon Purchaser's written request."[20] Additionally, "if any matters remain unresolved as of September 1, 2016, at the Purchaser's written request, the Representative and Purchaser shall meet to discuss the planned resolution of such remaining open matters."[21]

         The indemnification provision provides the remedy for losses related to "any of the matters set forth on the Specific Indemnity Schedule" if they "are actually incurred prior to October 14, 2016, " but it "shall not cover potential Losses from matters that are pending or otherwise have not been resolved prior to October 14, 2016."[22] In other words, the obligation to indemnify Sparton for the matters listed on the Specific Indemnity Schedule terminates on October 14, 2016 "regardless if any claims are still pending or the matters set forth on the Specific Indemnity Schedule remain pending and have not been settled or otherwise resolved . . ., [23] A Specific Indemnity Claim only arises once Sparton "actually incurs any out-of-pocket Losses indemnifiable under Section 11.01 (hi) of the Merger Agreement or there is a judgment or settlement permitted by the Merger Agreement of any matter covered by Section ll.Ol(iii) of the Merger Agreement."[24] The Specific Indemnity Claims are Sparton's sole and exclusive remedy for losses related to matters listed on the Specific Indemnity Schedule, except in the case of fraud.[25]

         The Specific Indemnity Schedule lists the matters it covers, including (a) the California State Board of Equalization (the "SBOE")'s determination of tax liability in early 2014 of $1, 436, 968.29 plus accruing interest arising from a company Hunter acquired in 2013; $130, 000.00 in sales tax that the acquired company did not report or remit to the SBOE; and certain unrealizable assets prepaid by Hunter, totaling $154, 577.00; and (b) the California Department of Toxic Substances Control ("DTSC")'s cleanup claim against 60 parties including Hunter regarding a hazardous waste repackaging facility called Ultra-Chem. The Complaint alleges that Sparton remains liable for both of these unresolved claims due to O'Neil's lack of "commercially reasonable efforts" to resolve them.[26]

         4. The anti-reliance provision

         The Agreement contains an anti-reliance provision that states as follows:

The representations and warranties of the Company expressly and specifically set forth in Article V (together with any representations and warranties expressly and specifically made by the Stockholders and Optionholders in their respective Letters of Transmittal and Option Cancellation Agreements), as qualified by the Disclosure Schedules, constitute the sole and exclusive representations, warranties, and statements (including by omission) of any kind or nature, whether written or oral, expressed or implied, statutory or otherwise (including, for the avoidance of doubt, relating to quality, quantity, condition, merchantability, fitness for a particular purpose or conformity to samples) of any of the Company, the Stockholders and Optionholders, the Representative or any of their respective Non-Recourse Parties as to any matter concerning the Company, any of its Subsidiaries or any of their respective joint ventures or businesses or in connection with this Agreement or the transactions contemplated by this Agreement, or with respect to the accuracy or completeness of any information provided to (or otherwise acquired by) the Purchaser or the Merger Sub or any of their respective Non-Recourse Parties in connection with this Agreement or the transactions contemplated by this Agreement (including, for the avoidance of doubt, any statements, information, documents, projections, forecasts or other material made available to the Purchaser, the Merger Sub or any of their respective Non-Recourse Parties in certain "data rooms" or presentations including "management presentations") and all other purported representations and warranties or statements (including by omission) are hereby disclaimed by the Company, the Stockholders and Optionholders, the Representative and each of their respective Non-Recourse Parties and none of the Purchaser or the Merger Sub or any of their respective Non-Recourse Parties shall have any claim with respect to their purported use of, or reliance on, any such representations, warranties or statements (including by omission). The Purchaser and the Merger Sub are otherwise acquiring the Company, its Subsidiaries, its joint ventures and their respective businesses on an "AS IS, WHERE IS" basis.[27]

         Thus, Sparton agreed that it did not rely on anything outside the representations and warranties contained in the Agreement in executing the Agreement.

         C. Procedural History

         Sparton filed its original complaint in this action on June 2, 2016. On July 22, 2016, the Defendants filed their answer, counterclaims, and partial motion to dismiss. On August 11, 2016, Sparton answered the Defendants' counterclaims. On September 14, 2016, Sparton filed the Complaint. On October 14, 2016, the Defendants filed their answer, amended and supplemental counterclaims, and partial motion to dismiss the Complaint. On November 7, 2016, Sparton filed its answer to the amended and supplemental counterclaims. On June 6, 2017, this Court held oral argument on the partial motion to dismiss the Complaint.

         II. ANALYSIS

         A. Standard of Review

         The Defendants move to dismiss for failure to state a claim under Court of Chancery Rule 12(b)(6). For the purposes of a motion to dismiss under Rule 12(b)(6),

(i) all well-pleaded factual allegations are accepted as true; (ii) even vague allegations are "well-pleaded" if they give the opposing party notice of the claim; (iii) the Court must draw all reasonable inferences in favor of the non-moving party; and (iv) dismissal is inappropriate unless the "plaintiff would not be entitled to recover under any reasonably conceivable set of circumstances susceptible of proof."[28]

         While I must draw all reasonable inferences in the plaintiff's favor, I need not "accept as true conclusory allegations 'without specific supporting factual allegations.'"[29]

         B.Sparton Fails to State a Claim for Breach ...


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