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3M Co. v. Neology, Inc.

Superior Court of Delaware

June 28, 2019

3M COMPANY Plaintiff,
v.
NEOLOGY, INC. and ONE EQUITY PARTNERS VI, L.P., Defendants.

          Submitted: March 25, 2019

         Upon Plaintiff's Motion to Dismiss Defendant Neology, Inc.'s First Amended Counterclaim: Granted in Part, Denied in Part

          Rafael X. Zahralddin-Aravena, Esquire, Jonathan M. Stemerman, Esquire of ELLIOTT GREENLEAF, P.C., Wilmington, Delaware, and Lawrence M. Shapiro, Esquire, Sybil L. Dunlop, Esquire of GREENE ESPEL PLLP, Minneapolis, Minnesota, Attorneys for Plaintiff.

          Catherine A. Gaul, Esquire of ASHBY & GEDDES, Wilmington, Delaware, and John D. Alessio, Esquire, Alex G. Brizolis, Esquire of PROCOPIO, CORY, HARGREAVES & SAVITCH LLP, San Diego, California, Attorneys for Defendant Neology, Inc.

          T. Brad Davy, Esquire, Jonathan A. Choa, Esquire of POTTER ANDERSON & CORROON LLP, Wilmington, Delaware, Attorneys for Defendant One Equity Partners VI, L.P.

          MEMORANDUM OPINION

          LeGrow, J.

         In May 2017, Buyer purchased Seller's tolling and automated license plate recognition business, and the parties executed an asset purchase agreement governing the sale. To complete the transaction, the parties also entered into several transition agreements requiring Seller to assist Buyer in the transition of the business. Seller initiated this action against Buyer after a dispute arose during the transition period. Buyer answered and asserted several counterclaims against Seller for breach of contract, fraud in the inducement, fraudulent concealment, indemnification, and breach of the implied covenant of good faith and fair dealing. According to Buyer, Seller misrepresented and intentionally concealed a major design flaw of one of its key products to induce Buyer into purchasing the business. Additionally, Buyer alleges Seller failed to perform its contractual obligations under the transition agreements.

         Currently before the Court is Seller's motion to dismiss Buyer's amended counterclaim for failure to state a claim. Seller has moved to dismiss the claims for procedural and substantive reasons, including that the claims are untimely under the contractual limitations period, fail to state a claim under the contract, and are contract claims masquerading as fraud claims. For the following reasons, I dismiss Buyer's implied covenant and breach of the asset purchase agreement counterclaims with prejudice and dismiss one of Buyer's breach of transition agreement counterclaims without prejudice. Buyer's remaining causes of action survive under the minimal pleading standard applicable to a motion to dismiss.

         FACTS AND PROCEDURAL BACKGROUND

         In 2017, 3M Company ("3M"), sold its tolling and automated license plate recognition ("ALPR") business (the "Business") to Defendant Neology, Inc. ("Neology"). Defendant One Equity Partners VI, L.P. acted as guarantor for Neology. The parties executed an Asset Purchase Agreement (the "APA") on May 4, 2017. As part of the transaction, 3M and Neology also entered into the Transition Distribution Services Agreement (the "Distribution Agreement"), the Transition Services Agreement (the "Service Agreement"), and the Transition Contract Manufacturing Agreement (the "Manufacturing Agreement") (collectively, the "Transition Agreements").

         The APA

         The APA, which set forth the terms and conditions of 3M's sale of the Business to Neology, contains several provisions essential to the parties' dispute.

         A. Representations and Warranties

         Article 3 of the APA contains representations and warranties 3M made to Neology. In Section 3.5, 3M specifically represented and warranted that there had been no "Material Adverse Effect" to the Business between December 31, 2016 and May 4, 2017. The APA defines a Material Adverse Effect as:

[A]ny state of facts, circumstance, condition, event, change, development, occurrence or effect (each, an "Effect") that is materially adverse to (a) the business, condition (financial or otherwise), assets, liabilities, operations or results of operations of the Business, taken as a whole or (b) the ability of [3M] to perform its obligations under this [a]greement or to consummate the transactions contemplated hereby ...[1]

         The definition of a Material Adverse Effect, however, expressly excludes any effect that:

[R] elates to, arises out of or results from . . . (vii) any failure by the Business to meet any internal or external estimates, expectations, budgets, projections or forecasts (but the underlying causes of such failure may so constitute or be taken into account unless such underlying causes would otherwise be excepted by another clause of this definition). . .[2]

         Elsewhere in the APA, Neology expressly disclaimed reliance on any representations and warranties except those contained in Article 3 of the APA (the "Non-Reliance Clause").[3] Specifically, Neology agreed that:

[I]t has relied solely upon its own independent investigation, review and analysis, and reached its own independent conclusions regarding, the Business and its operations, assets, condition (financial or otherwise) and prospects and has not relied on and is not relying on any representation, warranty or other statement made by, on behalf of or relating to [3M], [3M]'s [a]ffiliates or the Business except for the representations and warranties expressly set forth in Article 3 .. .[4]

         Neology agreed not to rely on any representations and warranties, except for those in Article 3, including any statements regarding "the operation or probable success or profitability of the Business" or "the accuracy or completeness of any information" made available to Neology in connection to the APA or in Neology's investigations of the Business.[5] Neology also disclaimed all rights and remedies arising out of any representation, warranty, or statement 3M made other than the representations and warranties expressly set forth in Article 3.[6]

         B. Covenants

         Article 5 of the APA sets forth both parties' covenants. Section 5.1 required 3M to continue to conduct the Business in its ordinary course before the transaction closed. 3M specifically promised that before closing it would:

[U]se commercially reasonable efforts to (A) operate the Business in the ordinary course of business, consistent with past practice . . . (B) maintain and preserve the present business organizations, assets and technology of the Business . . . and (C) maintain and preserve the relationships and goodwill with customers and suppliers of the Business.[7]

         C. Indemnification

         Article 10 of the APA provides both parties the right to indemnification for certain losses. Under Section 10.2, 3M is obligated to indemnify Neology for any losses arising from an inaccurate representation or warranty in Article 3 or any breach of covenant, agreement, or obligation to be performed by 3M under the APA. Section 10.8(a) makes indemnification the parties' exclusive remedy (the "Exclusive Remedy Clause"), and provides:

From and after the Closing, (i) this Article 10 shall be the sole and exclusive remedy of the [i]ndemnified [p]arties (including [Neology] and [3M]) in connection with this [a]greement and the transactions contemplated hereby, (ii) neither [Neology] nor [3M] shall be liable or responsible in any manner whatsoever (whether for indemnification or otherwise) to any [i]ndemnified [p]arty for a breach of this [a]greement or in connection with any of the transactions contemplated by this [a]greement . . . each [p]arty hereby waives, to the fullest extent permitted under applicable [l]aw, any and all rights, claims and causes of action (A) for any breach of any representation, warranty, covenant, agreement or obligation set forth herein or (B) otherwise relating to the subject matter of this [a]greement, in each case, that it may have against the other [p]arty ...

         Fraud claims, however, fall outside the Exclusive Remedy Clause, as Section 10.8(b) makes clear:

Nothing in this Article 10, but subject in all cases to the limitations in Section 4.8 and Section 11.3, shall limit either [p]arty's right to bring a claim until the latest time permitted by applicable [l]aw based on the [f]raud of any other [p]erson against such [p]erson in respect of any representation and warranty contained in Article 3 or Article 4 . ..

         The APA further sets certain limitations periods applicable to the APA's representations, warranties, and covenants. The representation in Section 3.5 expires eighteen months after the closing date.[8] All covenants and agreements that must be performed before the closing expire twelve months after the closing date.[9]In order to bring a timely claim, the complaining party must provide written notice within the survival period, including "a description in reasonable detail of (i) the basis for, and nature of, such Claim, including the facts constituting the basis for such Claim, and (ii) the estimated amount of the Losses that have been or may be sustained . . ."[10] Neither party is required to indemnify the other beyond the survival period, but if any claim is brought in good faith during the survival period, the claim survives until it is "fully and finally resolved."[11]

         If a timely claim is brought, Section 10.5(b) limits 3M's liability for indemnification to Neology, stating: "the maximum aggregate [l]iability of [3M] (i) under Section 10.2(a) shall be $300, 000, and (ii) under Section 10.2(a) and Section 10.2(b) together shall be the [p]urchase [p]rice." Section 10.2(a) refers to claims arising out of "any inaccuracy in any representation or warranty of [3M] contained in Article 3," and Section 10.2(b) refers to claims arising out of "any breach of any covenant, agreement or obligation to be performed by [3M] or any of its [a]ffiliates contained in or made pursuant to [the APA]."

         To summarize, claims under the APA - other than for fraud - must be noticed within the survival period applicable to that claim, are limited to claims for indemnification, and any resulting damages award is capped at $300, 000 in the case of inaccurate representations or warranties in Article 3, or at the purchase price in the case of a breach of any covenant.

         The Transition Agreements

         In addition to the APA, 3M and Neology also entered into the Transition Agreements. The Transition Agreements required 3M to perform certain services for Neology after the closing to assist with the transition of the Business. For example, the Service Agreement required 3M to provide Accounting and Finance Services, Information Technology Services, Supply Chain Services, and IT Systems Access Services.[12] In addition, under the Manufacturing Agreement, 3M agreed to manufacture and sell products.[13] The Distribution Agreement required 3M to sell products to customers and to accept and decline orders.[14] Each transition agreement contained a provision requiring 3M to perform these services for Neology with the same standard of care 3M would use for its own business.[15] Each transition agreement also contained a clause limiting 3M's liability to Neology for breach of the agreement. Specifically, 3M's maximum liability to Neology for breach of contract is $500, 000 under the Distribution Agreement, [16] $600, 000 under the Service Agreement, [17] and the total amount paid under the Manufacturing Agreement as of the date of the alleged breach.[18]

         This Litigation and Neology's Amended Counterclaims

         On July 11, 2018, following difficulties with the Business's transition, 3M brought this action against Neology and One Equity. Neology filed its answer along with counterclaims for breach of contract, fraud in the inducement, indemnification, and breach of the implied covenant of good faith and fair dealing. 3M moved to dismiss Neology's original counterclaims under Superior Court Civil Rule 12(b)(6), and Neology then filed amended counterclaims (the "Amended Counterclaims") containing additional breach of contract claims and a claim for fraudulent concealment. 3M again moved to dismiss and the parties briefed and argued that motion.

         The Amended Counterclaims focus on two sets of allegations: (1) before selling the Business to Neology, 3M misrepresented and concealed product development issues with the Business's new fixed ALPR camera (the "New Fixed Camera"), and (2) during the transition period, 3M failed to maintain an exemption needed for Neology legally to sell ALPR products in the European Union, and 3M sold ALPR products at below average gross profit margins.

         A. The New Fixed Camera

         Neology's first set of allegations concern undisclosed problems with the New Fixed Camera. Neology alleges that during due diligence, 3M provided several projections and forecasts for the Business that specifically referenced the New Fixed Camera. For example, a March 13, 2017 report by KPMG (the "KPMG Report") stated the Business would be launching the New Fixed Camera in mid-2017, "which would help drive and grow the ALPR gross margins."[19] The KPMG Report projected the New Fixed Camera "would account for 12.16% of the Business's fixed ALPR camera sales in 2017, 52.38% of the fixed camera sales in 2018, and 100% of the fixed camera sales in 2019."[20] An April 5, 2017 report by Ernst & Young LLP (the "E&Y Report") also noted that the Business was "focusing on developing new technology and not attempting to market/sell the aged technology."[21]

         Despite these statements, Neology contends 3M knew the New Fixed Camera would not be ready to launch by mid-2017. Neology cites a March 16, 2017 3M internal report (the "Thermal Report") suggesting the New Fixed Camera "suffer[ed] from 'serious overheating' issues."[22] According to Neology, 3M's efforts to resolve these design issues proved unsuccessful, and Neology did not discover the New Fixed Camera's overheating problem until after it acquired the Business. Neology further claims that despite diligent attempts to redesign the New Fixed Camera, it has been unable to resolve the overheating issue and get the product to market.

         Neology asserts several claims related to the overheating issue with the New Fixed Camera. First, Neology brings a breach of contract claim alleging the overheating issue was a "Material Adverse Effect" known to 3M as early as March 2017, and 3M therefore inaccurately represented and warranted in APA Section 3.5 that there had been no Material Adverse Effect to the Business since December 31, 2016. Neology also seeks indemnification for losses related to the inaccurate representation in Section 3.5. Next, Neology claims 3M's failure to disclose the camera's overheating issue was a violation of the APA's implied covenant of good faith and fair dealing. Finally, Neology claims 3M fraudulently induced Neology into purchasing the Business and intentionally and fraudulently concealed the Thermal Report.

         B. The RoHS 2 Exemption and Sale of ALPR Products

         The Amended Counterclaims also describe 3M's alleged failures to perform as required during the transition period. Neology first claims 3M breached its obligation to maintain an exemption from the European Commission's Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (the "RoHS 2 Exemption"). The RoHS 2 Exemption is a permit the Business needs to sell certain ALPR products in the European Union.[23] According to Neology, 3M obtained the RoHS 2 Exemption when it owned the Business, but 3M allowed the exemption to expire in July 2017 after the sale of the Business was complete. This lapse allegedly left Neology unable legally to sell ALPR products in the European Union almost immediately after it purchased the Business.

         Neology also alleges that during the transition period, 3M failed to sell ALPR products consistent with past practices, resulting in lower than normal gross profit margins. Neology specifically references the KPMG Report, which listed an average gross profit margin of "49.9% in 2014, 47.5% in 2015 and 28.9% in 2016" and reported "gross profit margin is expected to step-up from 29% in FY 2016 to a more normalized 41% in FY 2017, when compared to 48% gross margins achieved in FY 2015."[24] Despite this report, 3M sold ALPR products at an 8.45% gross profit margin during the transition period, and 3M continued to sell ALPR products at a gross profit margin of -396.54% after Neology terminated the Transition Agreements in November 2017.[25]

         Neology cites 3M's transition period conduct to support several of its claims. Neology first alleges that by failing to maintain the RoHS 2 Exemption, 3M breached its covenant in the APA to operate the Business before closing in the ordinary course and consistent with past practices. Neology also contends its losses related to the breach of covenant are subject indemnification. Neology offers similar allegations to support its claim for breach of the Transition Agreements. Neology alleges 3M was required to provide services consistent with 3M's past practices, but instead 3M failed to maintain the RoHS 2 Exemption and sold ALPR products at historically low gross margins. Finally, Neology contends this conduct supports its claim for breach of the APA's and the Transition Agreements' implied covenant of good faith and fair dealing.

         The Parties' Contentions

         In its motion to dismiss, 3M attacks the Amended Counterclaims as both procedurally and substantively deficient. 3M first argues Neology's claims are barred procedurally because Neology failed to follow contractually-mandated dispute resolution procedures, certain claims are untimely, and the original counterclaim improperly was amended under Superior Court Civil Rule 15(a). Next, 3M contends Neology's breach of contract claims under the APA must be dismissed because indemnification is the parties' exclusive remedy. As to Neology's indemnification claim, 3M argues that claim must be dismissed because Neology fails to plead the existence of a "Material Adverse Effect" as defined in the APA. Even if the indemnification claim survives, 3M contends the Court should strike the request for damages in excess of $300, 000. 3M also argues Neology's breach of contract claims under the Service Agreement and the Manufacturing Agreement must be dismissed because 3M was not obligated to maintain the RoHS 2 Exemption under those agreements. 3M contends the implied covenant claim should be dismissed because the express terms of the contract govern the conduct at issue. Finally, 3M argues the fraud claims impermissibly are bootstrapped to Neology's breach of contract claim and also are barred by the APA's Non-Reliance Clause.

         In response, Neology first argues its counterclaims are not barred procedurally because the parties have satisfied or waived any pre-litigation dispute resolution requirements; Neology's claims timely were noticed; and under a pragmatic interpretation of Rule 15(a), Neology's counterclaims properly were amended. As to the breach of contract claim under the APA, Neology argues it sufficiently pleads the existence of a Material Adverse Effect under the APA definition, and the remedy of indemnification does not affect its breach of contract claim. Neology also contends 3M's maximum liability is not $300, 000 because Neology alleges a violation of both APA Sections 10.2(a) and 10.2(b), for which 3M's maximum liability is the purchase price under the APA. As to the breach of contract claims under the Transition Agreements, Neology argues 3M contractually was obligated to maintain the RoHS 2 Exemption because 3M could not properly provide the contracted-for services without maintaining the exemption. Next, Neology contends that if the breach of contract claim does not survive, Neology sufficiently pleads breach of the implied covenant in the alternative. Finally, as to the fraud claims, Neology argues the Non-Reliance Clause does not bar its claims, and further, Neology alleges 3M made material misrepresentations and concealed material facts before the APA was executed, which brings the claim outside any argument regarding bootstrapping.

         ANALYSIS

         On a motion to dismiss, the Court must determine whether the "plaintiff 'may recover under any reasonably conceivable set of circumstances susceptible of proof.'"[26] "If [the plaintiff] may recover, the motion must be denied."[27] A court may grant the motion if "it appears to a reasonable certainty that under no state of facts which could be proved to support the claim asserted would plaintiff be entitled to relief."[28] When applying this standard, the Court will accept as true all non-conclusory, well-pleaded allegations. In addition, [29] "a trial court must draw all reasonable factual inferences in favor of the party opposing the motion."[30]

         I. Neology's counterclaims are not barred procedurally.

         In its motion to dismiss, 3M first argues the Amended Counterclaim must be dismissed due to procedural deficiencies, namely Neology's failure to: (1) engage in pre-litigation dispute resolution procedures, (2) properly amend its counterclaim under Superior Court Civil Rule 15(a), and (3) timely provide notice to 3M of Neology's claims under the APA and the Distribution Agreement.

         A. The parties have waived the APA's dispute resolution procedures.

         The APA contains a provision requiring the parties to engage in pre-litigation dispute resolution when any post-closing dispute arises.[31] Under Section 11.9, if a post-closing dispute arises, the parties must attempt to negotiate with one another, or, if negotiations are unsuccessful after thirty days, they must initiate non-binding mediation with a mutually-agreed upon mediator.[32] Neither party may initiate legal proceedings until forty-five days after appointment of a mediator.[33]

         3M contends Neology failed to comply with Section 11.9's dispute resolution procedures before filing the Amended Counterclaims, and Neology's claims therefore must be dismissed.[34] In response, Neology argues any pre-litigation dispute resolution requirement has been met or cured because the parties mediated after Neology filed the Amended Counterclaims, and further, 3M waived its right to insist on mediation when it initiated this litigation without mediating its own claims. Although 3M maintains this argument "on principle," 3M acknowledged at oral argument that this point largely is moot due to post-filing events. I agree. Here, the parties' actions indicate they have waived strict compliance with the APA's dispute resolution procedures.[35] The parties mediated without success in February 2019 after the Amended Counterclaims were filed, [36] and according to Neology, 3M itself failed to comply with the APA's dispute resolution procedures before filing this action.[37] Accordingly, the APA's dispute resolution procedures have been waived for purposes of this dispute.

         B. A motion to dismiss is not a responsive pleading under Superior Court Civil Rule 15(a).

         Superior Court Civil Rule 15(a) provides, "[a] party may amend the party's pleading once as a matter of course at any time before a responsive pleading is served or . . . Otherwise, a party may amend the party's pleading only by leave of court or by written consent of the adverse party . . ."[38] 3M contends their original motion to dismiss is a "responsive pleading," and Neology's Amended Counterclaims therefore must be dismissed because the claims were filed without 3M's consent or leave from the Court.[39]

         A motion to dismiss, however, is not a responsive pleading. This conclusion is consistent with the Court's rules, Delaware case law, and the notion of judicial efficiency.[40] Permitting one amendment as a matter of right in the face of a motion to dismiss encourages a plaintiff to address, if possible, any deficiencies in an initial complaint and proceed on its best set of allegations. If, even after amendment, the complaint remains deficient, a defendant would have a strong argument to seek dismissal with prejudice. Accordingly, Neology was not required to seek 3M's consent or leave from the Court, and Neology's Amended Counterclaims properly were filed under Rule 15(a).

         C. Neology sufficiently pleads that it provided timely notice of a dispute under the Distribution Agreement and the APA.

         Next, 3M argues Neology's breach of covenant claim under the APA and breach of contract claim under the Distribution Agreement both are untimely. According to Neology, however, it gave 3M timely notice of its claims, and regardless, timeliness is a question of fact not amenable to resolution on a motion to dismiss. Under Delaware law, parties to a contract may shorten the statute of limitations.[41] Both the APA and the Distribution Agreement expressly limit the time period for a party to bring a claim.

         The limitations period in the APA prohibits any claim for breach of covenant brought twelve months after the closing date.[42] To preserve a claim, the complaining party must provide written notice of the claim within twelve months of closing, including descriptions of the nature of the claim and the estimated loss.[43] The closing date was June 30, 2017, therefore notice of any claim for breach of covenant was required by June 30, 2018.[44] Under ...


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