United States: Chancery Court Holds That Express Merger Provisions Prevail Over Alleged Extra-Contractual Misrepresentations

Last Updated: September 28 2017
Article by Josh Gaul and William H. 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 merger agreement (the "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 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 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 Agreement's specific indemnity schedule. Under the 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 the 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.

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

The Court sided with the 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 Agreement's anti-reliance provision, which limited Sparton to the representations and warranties in the 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 state of mind the 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 the defendants, made the pertinent representations under the 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 the 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 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 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 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 Agreement.

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

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