Black Friday Needs to Start Really Early: Risk of Material Adverse Effect

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Warning shoppers—or, rather, sellers: a company’s failure to meet sales forecasts may amount to a material adverse effect.

In Osram Sylvania Inc. v. Townsend Ventures, LLC, Osram Sylvania Inc. (OSI), a stockholder of Encelium Holdings, Inc., agreed to purchase the other issued and outstanding capital stock of Encelium not already held by OSI pursuant to a stock purchase agreement, which was executed on the last day of the third quarter of 2011. The $47 million purchase price was based on Encelium’s forecasted sales for the 2011 third quarter, estimated at $4 million, as well as representations relating to Encelium’s financial condition, operating results, income, revenue and expenses.

Following the October 2011 closing, OSI became aware that Encelium’s third quarter results were approximately half of its $4 million forecast and alleged that Encelium and the sellers knew of the results prior to closing. OSI further alleged that Encelium’s and the sellers’ failure to disclose these results prior to closing violated a provision in the stock purchase agreement that required them to disclose facts amounting to an (MAE). Finally, OSI alleged that Encelium and the sellers had manipulated Encelium’s second quarter results to make its business appear more profitable than it was.

On November 19, 2013, the Delaware Court of Chancery (Vice Chancellor Parsons) declined the sellers’ motion to dismiss the claims. In considering the sellers’ motion to dismiss, OSI’s contract and tort-based claims, the court held that:

  • Financial manipulation prior to execution of a purchase agreement may lead to an MAE. The court concluded that it was reasonably conceivable that the alleged practices of billing and shipping excess product without applying proper credits or discounts and the restructuring of Encelium’s business segments could produce a material adverse effect on Encelium’s business and operations, which the sellers warranted against.
  • Failure to meet sales forecasts may lead to an MAE. The court found that the third quarter results, that Encelium had made only half of its forecasted sales, 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 covenants survived the motion to dismiss.
  • OSI met the heightened pleading standards applicable to its fraud claim. The court held that OSI had pled the elements of fraud with sufficient particularity to satisfy the heightened pleading standards applicable to common law fraud claims and OSI also pleaded a claim for negligent misrepresentation based on the sellers’ alleged manipulation and concealment of financial information before the closing. As to OSI’s equitable fraud claim, however, the court determined that OSI did not make the necessary allegations of any special relationship of trust or confidence between OSI and the sellers, and therefore granted sellers’ motion to dismiss as to OSI’s equitable fraud claim.
  • No implied contractual obligations were identified to support a claim based on the implied covenant of good faith and fair dealing. The court determined that the implied covenant of good faith and fair dealing was not applicable, given that the sellers’ obligations were governed by express contractual provisions of the agreement, and dismissed OSI’s claim under the implied covenant.