Chancery Court Holds that Express Merger Provisions Prevail Over Alleged Extra-Contractual Misrepresentations

By Josh Gaul and Will Smith

In Sparton Corporation v. Joseph F. O’Neil et al., Civil Action No. 12403-VCMR (Del. Ch. August 9, 2017), the Delaware Court of Chancery granted the defendants’ motion to dismiss in its entirety because the plaintiff failed to state a claim for fraud and breach of contract. Seeking extra-contractual relief from a merger agreement, the plaintiff-buyer claimed, among other losses, $1.8 million in damages caused by the sellers’ misrepresentation of the target company’s working capital. The plaintiff argued that the defendant-sellers’ alleged extra-contractual misrepresentations warranted judicial intervention despite express anti-reliance and exclusive remedy provisions in the merger agreement.

In April 2015, the plaintiff Sparton Corporation (“Sparton”), an Ohio company, entered into an agreement to acquire Hunter Technology Corporation (“Hunter”), a California corporation through a merger. The defendants were Hunter’s stockholders and optionholders (the “Defendants”). The merger agreement (the “Merger Agreement”) was negotiated and executed by Defendant O’Neil, acting as the representative for the then-current Hunter stockholders and optionholders. Sparton’s subsidiary Sparton Hunter Corporation (the “Merger Sub”) also signed the Merger Agreement, where Hunter was to survive as Sparton’s wholly-owned subsidiary. The merger was consummated for a $55 million purchase price.

The parties agreed on several separate escrow funds pursuant to the Merger Agreement: (i) a $750,000 purchase price adjustment escrow fund for post-closing working capital adjustments; (ii) a $550,000 indemnification escrow fund for breaches in Hunter’s representations and warranties and other liabilities; and (iii) a $1.5 million special indemnity escrow fund to cover potential losses incurred before October 14, 2016 caused by matters listed on the Merger Agreement’s specific indemnity schedule. Under the Merger Agreement, Sparton’s sole and exclusive remedy for any overstatement in estimated working capital or losses arising from matters on the specific indemnity schedule was, respectively, the purchase price adjustment escrow fund and the indemnity escrow fund.

Sparton alleged a claim for fraud and three claims for breach of contract related to the merger. Sparton claimed that the Merger Agreement was fraudulently induced because Defendants used fabricated financial statements to negotiate the working capital estimate, the purchase price adjustment escrow amount, and the $750,000 cap on the post-closing working capital adjustment. Sparton also alleged breach of contract on two main grounds: (i) Hunter’s inflated working capital estimates breached Hunter’s representations and warranties; and (ii) Defendant O’Neil failed to use commercially reasonable efforts to resolve certain liabilities listed on the specific indemnity schedule.

Defendants argued in reply that Sparton failed to meet the heightened pleading standard for fraud. They also argued the Merger Agreement barred both breach of contract claims and that Sparton failed to state a claim for a breach of contract regarding the specific indemnities. Defendants did not challenge Sparton’s third breach of contract claim related to certain fees and collection expenses.

The Court sided with Defendants, dismissing the fraud and two contract-breach claims. The Court held that Sparton failed to allege adequately a claim for fraud. Under the Court of Chancery’s heightened pleading standard for fraud, a complaint “must allege: (1) the time, place, and contents of the false representation; (2) the identity of the person making the representation; and (3) what the person intended to gain by making the representations.” The Court highlighted in particular the Merger Agreement’s anti-reliance provision, which limited Sparton to the representations and warranties in the Merger Agreement and attached documents, and excluded any representations made by Defendant O’Neil or others during the merger negotiations.

The Court found that Sparton failed to allege with any specificity who, when, and with what state of mind Defendants fraudulently overstated Hunter’s financials. Sparton claimed that it could not “yet identify the specific roles of the co-conspirators” who allegedly exaggerated Hunter’s working capital and accounts receivable. Further, Sparton did not allege whether the contested financial statements were created before or after the deal was negotiated, information necessary for evaluating Sparton’s claim that the merger was fraudulently induced. And Sparton failed to allege that the defendant stockholders and optionholders of Hunter were in a position to know the veracity of Hunter’s financials: Hunter, not Defendants, made the pertinent representations under the Merger Agreement regarding accurate financial statements. Sparton failed to satisfy the Chancery Court standard because these non-specific and generalized allegations did not support the inference that Defendants in particular falsely bolstered Hunter’s financial condition during the negotiations in an effort to defraud Sparton with misleading financial data.

The Court also held that Sparton failed to state a claim for a breach of contract for the alleged specific indemnity damages. The Merger Agreement expressly stated that the specific indemnity escrow fund was the sole and exclusive remedy for losses arising from those items included on the specific indemnity schedule and prevented recovery for unresolved claims after October 14, 2016. The Court dismissed the specific indemnities claim because Sparton had not incurred actual out-of-pocket losses before the October 14 termination date. Sparton’s conclusory allegation that “Defendants’ conduct has made exact conformance to the Merger Agreement impossible” was insufficient to state claim.

The Court similarly held that Sparton’s breach of contract claim related to working capital was defeated as a fraud claim and was otherwise barred by the Merger Agreement’s express cap on the purchase price adjustment escrow funds. That fund was Sparton’s sole and exclusive recourse for any post-closing working capital adjustments under the Merger Agreement. Sparton did not contest that these contractual limits applied or that it received the full escrow amount. Because Sparton received the $750,000 amount in full, the court found that Sparton was properly barred from any additional recourse to the indemnity escrow fund by the Merger Agreement.

UPDATE as of June 18, 2018:

In a sequel letter opinion, Sparton Corporation v. Joseph F. O’Neil et al., Civil Action No. 12403-VCMR (Del. Ch. June 18, 2018), the Court granted Defendants’ motion for partial judgment on the pleadings and motion for interim attorneys’ fees.  The dispute at issue in this seriatim decision was Sparton’s refusal to release $838,000 held in escrow pursuant to the Merger Agreement and a contemporaneous escrow agreement (“Escrow Agreement”).  On October 14, 2016, Defendants counterclaimed that the Merger and Escrow Agreement required Sparton to release the escrow funds.  On September 22, 2017, Defendants moved for partial judgment on the pleadings under Court of Chancery Rule 12(c), seeking release of the escrow funds by a “Joint Release Instruction” and attorneys’ fees in the amount of $447,564.03.

The Court held that that because Sparton did not incur out-of-pocket expenses related to the specific indemnity escrow fund prior to October 14, 2016, Sparton had no right to withhold the escrow funds under either the Merger or Escrow Agreement.  The Court also ruled that Defendant’s request for a mandatory injunction ordering Sparton to release the escrow funds was the appropriate form of relief.  The Court found that the balance of equities favored an injunction because Sparton never had a contractual right to the escrow funds, and Defendants had proven they were entitled to the release of the same funds under the relevant agreements.  In addition, the Merger Agreement acknowledged that irreparable harm would be suffered in the event that an obligation was breached and permitted injunctive relief as an appropriate remedy for such injury.  Finally, the Court held that an award for interim attorneys’ fees was warranted.  The Merger Agreement provided for “prevailing party” fee awards in the event of litigation arising from a fraud claim or from the specific indemnity provisions.  Because Defendants actually incurred expenses arising from precisely these two types of claims, and also prevailed over Sparton in the subsequent litigation of such claims (as detailed in the Court’s prior opinion), the Court ruled that the requested fees were both reasonable and recoverable.

Sparton Corporation v. O’Neil et al. memorandum opinion 170809

Sparton Corporation v. O’Neil et al. letter opinion 180618

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