Sparton Corp. v. O’Neil, et al., C.A. No. 12403-VCR (Del. Ch. Aug. 9, 2017) – In this opinion, the Delaware Court of Chancery addressed a situation in which a purchaser of a company discovered that the actual amount of working capital was less than the estimated working capital agreed to by the parties. In this instance, the merger agreement provided for a cap on damages on the purchaser’s remedies to cover any deficiency in the difference between the estimated pre-closing working capital and the actual working capital. Unfortunately, when the purchaser realized the true extent of its loss and sought to recover damages in excess of the cap, the Court gave effect to the terms of the merger agreement by dismissing purchaser’s claims.

This lawsuit arose out of Sparton Corporation’s acquisition of Hunter Technology Corporation, in which Sparton alleged that certain shareholders and optionholders of Hunter misrepresented financial data that affected Hunter’s pre-closing estimate of working capital, the escrow amount, and the cap on post-closing adjustment on working capital. The merger agreement included certain representations and warranties concerning Hunter’s financial data, specifically the warranties that Hunter’s financial statements were based on information set forth in the company’s books and records, such books and records were prepared in accordance with GAAP, and the information was accurate as of the time that it was provided to Sparton. The shareholders and optionholders agreed to indemnify Sparton for any losses related to a breach of any misrepresentation concerning the financial data unless the loss was “included in the calculation of the final Allocable Amount.”  The Allocable Amount included the calculation of Hunter’s working capital.

The parties agreed to use a pre-closing estimate of Hunter’s working capital based on Hunter’s March 31, 2015, financial statements and a post-closing adjustment process. The merger agreement provided that if the actual Allocable Amount was less than the estimated Allocable Amount, then the escrow agent would pay Sparton the difference from money held in escrow. The merger agreement further provided that “[a]ny such payments shall be the sole and exclusive remedy of the Purchaser for any and all claims” concerning the calculation of the Allocable Amount in the absence of fraud. Based on representations from the shareholders and optionholders that the deficiency would be minimal, the parties agreed to cap the working capital adjustment at $750,000. It is worth noting that these representations were not set forth in the merger agreement. Furthermore, of extreme relevance is the fact that the merger agreement contained an anti-reliance provision.[1]

After the sale closed, Sparton learned that the post-closing working capital adjustment was approximately $2.6 million. Sparton sought payment of the deficiency, and it received the $750,000 held in escrow without dispute. The shareholders and optionholders, however, refused to pay any additional money to remedy Sparton’s damages. The merger agreement required the shareholders and optionholders to use “commercially reasonable efforts” to settle indemnity disputes on “commercially reasonable terms” within 18 months of closing. The obligation to indemnify thereafter terminated on October 14, 2016, in accordance with the merger agreement.

Sparton filed suit against the shareholders and optionholders (collectively, the “Defendants”) for breach of contract and fraud. Sparton alleges that the Defendants misrepresented Hunter’s financial data, breached the warranties concerning Hunter’s financial statements and failed to exercise “commercially reasonable efforts” to resolve certain liabilities. The Defendants moved to dismiss the Complaint in part, which the Court of Chancery granted.

First, the Court of Chancery found that Sparton failed to allege a claim for breach of contract related to the purported breach of warranties concerning Hunter’s financial statements. Sparton’s sole and exclusive remedy was the funds held in escrow, which the escrow agent paid. While the Defendants possessed a duty to indemnify, the indemnification obligation terminated on October 14, 2016. Further, an escrow claim “does not arise until Sparton actually incurs out-of-pocket losses, a judgment is issued, or settlement is reached.”  Accordingly, Sparton did not possess a viable claim for breach of contract. Sparton argued that the Defendants’ conduct rendered performance under the merger agreement impossible, because the Defendants failed to exercise “commercially reasonable efforts.”  The complaint, however, did not identify how the Defendants failed to exercise “commercially reasonable efforts,” and the Court of Chancery found that such conclusory allegations could not survive a motion to dismiss.

Second, the Court of Chancery found that Sparton’s allegations of fraud concerning the Defendants’ purported misrepresentations were not sufficiently pled. The merger agreement stated that the money held in escrow was Sparton’s sole and exclusive remedy for any claims arising out of the Allocable Amount. Since Sparton had already received the $750,000 held in escrow, it looked for other potential sources from which it could recover payment of its remaining damages. The indemnity provision precluded recovery thereunder for losses arising out of the calculation of the Allocable Amount, except in the case of fraud. In light of this limited window, Sparton alleged that the Defendants’ fraudulent conduct rendered the limitations on indemnity inapplicable. The Court did not find this argument persuasive. The anti-reliance provision prohibited Sparton from “premising a fraudulent inducement claim on statements of fact it had previously said were neither made to it nor had an effect on it.”  The Complaint failed to allege the individual acts of fraud purportedly committed by the Defendants with the requisite particularity. Moreover, the pleadings failed to show that the Defendants personally represented that any of the financial data was accurate. Accordingly, the Court dismissed the claim.

The Court of Chancery’s decision highlights Sparton’s failure to protect its interests. The purchaser purportedly relied on certain representations made by the Defendants regarding Hunter’s working capital, notably that the difference between the estimated Allocable Amount and the final Allocable Amount was minimal. Despite its reliance on these representations, Sparton neither incorporated the representations in the merger agreement nor eliminated the restrictions on the Defendants’ indemnity obligations. The cap on the amount held in escrow further undermined Sparton’s efforts. Sparton’s inability to recover its losses reflects the importance of contractual protections to guard against risk associated with the uncertainty of assessing a target company’s financials.

[1] Please see our summary on anti-reliance provisions at http://www.mccarter.com/Delaware-Law-Updates--FdG-Logistics-LLC-v-AR-Logistics-Holdings-Inc-CA-No-9706-CB-Del-Ch-Feb-23-2016-03-09-2016.