Delaware Court: Missed Sales Forecasts Could be “Material Adverse Effect”

Posted by Kobi Kastiel, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Sunday December 8, 2013 at 9:06 am
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Editor’s Note: The following post comes to us from Robert B. Schumer, chair of the Corporate Department at Paul, Weiss, Rifkind, Wharton & Garrison LLP, and is based on a Paul Weiss client memorandum. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

In Osram Sylvania Inc. v. Townsend Ventures, LLC, the Delaware Court of Chancery (VC Parsons) declined to dismiss claims by Osram Sylvania Inc. that, in connection with OSI’s purchase of stock of Encelium Holdings, Inc. from the company’s other stockholders (the “Sellers”), Encelium’s failure to meet sales forecasts and manipulation of financial results by the Sellers amounted to a material adverse effect (“MAE”). The decision was issued in the context of post-closing indemnity claims asserted by OSI against the Sellers and not a disputed closing condition.

OSI, a stockholder of Encelium, agreed to purchase the remaining capital stock of Encelium not held by OSI pursuant to a stock purchase agreement executed on the last day of the third quarter of 2011. The $47 million purchase price was agreed based on Encelium’s forecasted sales of $4 million for the third quarter of 2011, as well as Sellers’ representations concerning Encelium’s financial condition, operating results, income, revenue and expenses. Following the closing of the transaction in October 2011, OSI learned that Encelium’s third quarter results were approximately half of its forecast and alleged that Encelium and the Sellers knew about these sales results, but failed to disclose them at closing in violation of a provision in the agreement requiring them to disclose facts that amount to an MAE. OSI also alleged other misconduct by Encelium and the Sellers, including, among other things, that they had manipulated Encelium’s second quarter results to make its business appear more profitable.

In considering the Sellers’ motion to dismiss OSI’s contract and tort-based claims, the court held that:

  • Acts of financial manipulation prior to execution of the agreement could lead to an MAE. The court denied Sellers’ motion to dismiss OSI’s contract claims based on allegations that Encelium and Sellers used tactics to inflate sales and manipulated and concealed Encelium’s second quarter financial information, thereby breaching warranties in the agreement. Notably, the court held that it was reasonably conceivable that Sellers’ acts of financial manipulation before signing, such as an alleged practice of billing and shipping excess product without applying proper credits or discounts and the restructuring of Encelium’s business segments, could produce an MAE, the existence of which Sellers had warranted against.
  • Failure to meet sales forecasts could be an MAE. OSI alleged that shortly after signing, Sellers learned that Encelium’s third quarter sales results were only half of its forecast, but nonetheless failed to disclose this fact at closing in violation of a covenant requiring Sellers to disclose MAEs occurring before closing. The court determined that the third quarter results could be interpreted as reflecting a change in circumstances that was materially adverse to Encelium’s business, and therefore held that OSI’s claim based on a breach of the applicable covenant survived the motion to dismiss.
  • OSI met the heightened pleading standards applicable to its fraud claim. The court determined that OSI had satisfied the heightened pleading standards applicable to common law fraud claims, and also pleaded a claim for negligent misrepresentation, based on its allegations that Sellers made false representations regarding the financial condition, operating results, income and expenses of Encelium’s business in the second quarter of 2011. The court, however, did grant Sellers’ motion to dismiss as to OSI’s equitable fraud claim, as it made no allegations of any special relationship of trust or confidence between OSI and Sellers, which is necessary for a claim of equitable fraud.
  • No implied contractual obligations existed to support a claim based on the implied covenant of good faith and fair dealing. Because Sellers’ obligations were governed by express contractual provisions of the agreement, the court held that the implied covenant of good faith and fair dealing was inapplicable and dismissed OSI’s claim under the implied covenant.

 

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