Chancery Allows Fraud and Breach of Contract Claims Against Seller of Stock

The following article first appeared in a recent edition of The Delaware Business Court Insider.

A recent decision of the Delaware Court of Chancery in the case of Osram Sylvania, Inc. v. Townsend Ventures, LLC, C.A. No. 8123-VCP (Del. Ch. Nov. 19. 2013), denied a motion to dismiss a breach of contract claim and a fraud claim brought against the seller of stock. The buyer claimed that the seller knew before closing that the company had underperformed substantially compared to forecasts but concealed this fact from the buyer and manipulated the financial condition of the company in the period leading up to the execution and the closing of the agreement in order to make the company appear more successful than it actually was. However, the court granted a motion to dismiss claims for equitable fraud and breach of the implied covenant of good faith and fair dealing, although the claim for common law fraud was allowed to proceed, along with an indemnification claim.

The parties entered into a stock purchase agreement (“SPA”) in which Osram Sylvania, Inc. (“OSI”) agreed to purchase from the defendants the remaining shares of a company called Enselium that it had not already owned.  In 2001, the defendants provided OSI with a presentation about Enselium that included information about its sales and financials, its competitive landscape and a review of its operations.  The presentation revealed that Enselium was projecting sales for 2011 of approximately $18 million and that two of its employees were responsible for about 32% of the sales forecasted for 2011.  The defendants understood that the 2011 forecast number was integral to OSI’s analysis of the purchase price it would pay for Enselium.  OSI agreed to pay approximately $47 million for the remaining capital stock of Enselium.  The transaction closed in October of 2011.

After the closing, OSI learned that instead of the $4 million forecasted for sales in the third quarter of 2011, the actual sales for the third quarter were approximately ½ of that forecasted number.  OSI alleged that the defendants knew that the actual sales of Enselium for the third quarter of 2011 were approximately ½ of the amount forecasted but did not inform OSI of that underperformance, even though the defendants knew of the drastic difference before the closing date.  OSI also discovered after the closing that the defendants allegedly manipulated the financials for the second quarter of 2011 to hide the fact that the actual financials were not as presented.

OSI sought indemnification based on the provisions of the SPA that required the defendants to indemnify for losses incurred as a result of breaches of the SPA.  The indemnification provision also covered breaches as a result of inaccuracies in representations made in the agreement.  There was a threshold of $200,000 for indemnification to apply.

OSI alleged that the manipulation and the concealment of the financial condition of the company breached the warranties in the SPA regarding the accuracy of the financial statements and the accuracy and completeness of the representations in the agreement.  The defendants argued that those allegations were merely conclusory and not supported by specific allegations.  The court, however, found that the allegations of OSI were adequately plead.  For example, OSI referred to specific revenues that were inflated by billing and shipping excess product without applying proper credits or discounts.  Taking those well plead factual allegations as true, the court found it would be reasonably conceivable that they could succeed in demonstrating that the inflation of sales and financial manipulation resulted in statements that did not fairly present the financial condition of the company and therefore breached the SPA.

Using the word possibility as a synonym for conceivability, the court also reasoned that there was a reasonable possibility that OSI could demonstrate that the changes in the business practices of Enselium in the period leading up to the closing could be expected to produce a “material adverse change,” thereby breaching the representations in the SPA.

The court also explained that it is reasonably conceivable that OSI could prove damages resulting from the breaches.  The financial manipulation is alleged to have resulted in breaches of the SPA that made the company appear to be more successful than it actually was.  Therefore that conduct may have caused OSI to agree to pay more for the company than it otherwise would have.

The court observed that OSI advanced the claim for indemnification based on the same allegations that support its breach of contract claims.  For purposes of indemnification, even if the court were to dismiss the breach of contract claim regarding the loss of two key employees, the court would be required to uphold the claim for indemnification based on the departure of those employees if that departure conceivably could be shown to constitute an adverse change.

The court also explained that because OSI alleged damages in excess of $8 million, the allegations make it reasonably conceivable that OSI could demonstrate that it exceeded the threshold of $200,000 in damages which would trigger the indemnification obligations under the SPA.

The court addressed the elements of fraud and whether the allegations satisfied the particularity requirement under Court of Chancery Rule 9(b) for averments of fraud.  Rule 9 requires a complaint alleging fraud to state:  (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 representation.  Conditions of mind, however, such as malice, intent and knowledge, may be averred generally.  Essentially, the court described the particularity requirement as obligating the plaintiff to allege the circumstances of the fraud “with details sufficient to apprise the defendant of the basis for the claim.”  The court found that OSI did allege with particularity facts supporting a claim of fraud.

The court distinguished forecasts about events that will occur in the future and “opinions and statements as to probable future results” as not generally being fraudulent even though they relate to material matters.  It follows that failing to disclose information to correct earlier forecasts is not actionable in fraud.

The opinion provides a helpful analysis of the nuances required to satisfy the prerequisites of particularity for a fraud claim.  Regarding the state of mind required for fraud, the court explained that a mere allegation that a defendant “knew or should have known” about a false statement is not sufficient to plead the requisite state of mind.  Although state of mind can be alleged generally, the court found that the defendants conceivably were knowing participants in an effort to defraud OSI.

Moreover, the court emphasized settled Delaware law that a plaintiff “cannot bootstrap a claim of breach of contract into a claim of fraud merely by alleging that a contracting party never intended to perform its obligations.”  Stated differently, the plaintiff cannot state a claim for fraud simply by adding the term “fraudulently induced” to a complaint that states a claim for breach of contract or by alleging that the defendant never intended to abide by the agreement at issue when the parties entered into it.  The court explained that this was not a situation where a claim improperly based fraudulent intent solely on subsequent activity and hindsight attempts to infer fraudulent intent based on activity that occurred after the date of the alleged fraud.

This opinion should be required reading for anyone planning to prevail on a claim for breach of contract and fraud in connection with the purchase of stock or assets of a company.