Delaware Court of Chancery Analyzes Failure to Meet Projections and Loss of Key Salespeople as Triggers of MAC

Practical Law Legal Update 5-549-9685 (Approx. 5 pages)

Delaware Court of Chancery Analyzes Failure to Meet Projections and Loss of Key Salespeople as Triggers of MAC

by Practical Law Corporate & Securities

Background

The plaintiff, Osram Sylvania Inc. (OSI), acquired the stock of Encelium Holdings, Inc. from the sellers Townsend Ventures LLC, certain affiliates of Townsend, and three other individuals. The sale was made pursuant to a stock purchase agreement dated September 30, 2011, and closed on October 14, 2011. The purchase price, subject to certain adjustments, was $47 million, which OSI agreed to pay based in large part on the sellers' representations about Encelium's sales in the second and third quarters of 2011. In the lead-up to the signing, the sellers also informed OSI that two of Encelium's salespeople together were responsible for approximately 32% of the company's forecasted sales for 2011.

After the closing, OSI learned that Encelium's sales for the third quarter were only half of those that the sellers had projected. OSI also alleged that:

The sellers had manipulated Encelium's second-quarter sales figures.
The sellers knew by the closing date that the two salespeople had resigned, yet did not notify OSI of the resignations.
As of the closing, the sellers were aware that Encelium had a significant liability that they had not accounted for in Encelium's financial statements or otherwise disclosed to OSI.
The sellers had maintained inventory of a particular product far in excess of the amount that they had represented.

Based on these allegations, OSI brought claims against the sellers on several theories, including fraud, equitable fraud, breach of warranty, breach of covenant, indemnification and breach of the implied covenant of good faith and fair dealing. The contractual claims were premised on breaches of the following representations, warranties and covenants:

The "Financial Statements" representation as to the accuracy of Encelium's financial statements through the second quarter of 2011, which were represented as "correct and complete in all material respects."
The "Absence of Changes" representation that the business had been operated in the ordinary course of business consistent with past custom and practice, and that no event had occurred that had resulted in, or would reasonably be expected to result in, a "Material Adverse Change."
The "No Undisclosed Liabilities" representation that all liabilities had been accrued or reserved against on the balance sheet, incurred in the ordinary course of business, or disclosed, and that the ordinary-course liabilities did not, individually or in the aggregate, have a Material Adverse Effect on the business.
The "Inventory" representation that Encelium's inventory had been accurately disclosed and was historically consistent with past practice.
The "No Material Adverse Effect" representation that no change or event had resulted in, or would reasonably be expected to result in, a "Material Adverse Effect."
The "10b-5" representation that no representation or warranty of the sellers contained any untrue statements of material fact, or intentionally omitted to state any material fact necessary to make the statements not misleading.
The covenant to operate the business between signing and closing in the ordinary course.
The covenant to notify OSI of any fact or circumstance that would, or would reasonably be expected to have, individually or in the aggregate, a Material Adverse Effect.

All of these provisions are standard, particularly in a pro-buyer purchase agreement, and are described in Standard Document, Stock Purchase Agreement (Pro-Buyer Long Form).

The definition of a MAC and the allegation that it had been breached were central to OSI's claims, with two of the allegedly breached representations being qualified by a MAC, and the "No Material Adverse Effect" representation and the disclosure covenant both directly implicating that term. The purchase agreement defined both "Material Adverse Change" and "Material Adverse Effect" as "any effect or change... that would be materially adverse to the Business, assets, condition (financial or otherwise), results, or operations" of Encelium. OSI claimed that the inflated third-quarter sales projections and manipulations to the second-quarter figures, as well as the resignation of the two salespeople, were material enough to the business's long-term performance to constitute a MAC.

The sellers argued that several of OSI's claims were duplicative of each other, and that OSI had failed to state a valid claim for breach of the purchase agreement or for fraud. Regarding the MAC-based claims that turned on the resignation of the two salespeople, the sellers argued that:

Turnover is a normal part of business and is not a MAC that requires particular disclosure to the buyer.
The carve-out for "general business or economic conditions" excludes ordinary events like employee resignations.
The two salespeople were not listed in the definition of "Key Personnel," which meant that their resignation could not have been material enough to qualify as a MAC.
The resignations were disclosed by virtue of the fact that the two salespeople's names were not included on the final version of the schedule of current employees.

Outcome

The court analyzed each of OSI's claims and agreed that some were duplicative. For example, the court held that the breach of warranty claim was duplicative of a breach of contract claim, while the claim of a breach of the implied covenant of good faith and fair dealing was duplicative because it was premised on obligations that were or could have been addressed contractually.

Significantly, the court found a reasonable conceivability that OSI would succeed on its MAC claims based on the sellers' alleged manipulation of Encelium's second-quarter sales figures and failure to meet third-quarter projections, but not on the basis of the salespeople's resignations. The court found, for purposes of ruling on a motion to dismiss, that the misrepresented sales results could pass the MAC threshold because:

The sellers' practice of billing and shipping excess product, without applying the proper credits or discount, could have a materially adverse effect on the business's financial condition when the excess product is returned and revenues are reduced.
The sellers' restructuring of Encelium's business segments produced short-term gains at the cost of long-term viability.

The court also went through each of the sellers' arguments for why the two resignations could not have constituted a MAC. First, the court rejected their argument that the "general business" carve-out excluded the resignations. As the court explained, that carve-out is understood to apply to general economic or industry-wide downturns, not events that happen specifically at the company. The court also did not accept that omitting the names of the two salespeople from the disclosure schedule necessarily satisfied the sellers' notice obligation if the resignations were in fact a MAC. Rather, if the resignations were to have constituted a MAC, the sellers would have been required to affirmatively notify OSI of the resignations.

However, the court did accept the sellers' other arguments for why the two resignations could not have been a MAC. The court agreed that employee turnover is a regular occurrence in business and does not typically rise to the level of a MAC. Though it is possible for certain resignations to constitute a MAC, the significance of the two employees here was based on their projected sales performances, which are speculative and uncertain. The loss of performance that is itself speculative is harder to form the basis for a MAC. In addition, the court agreed that OSI's failure to negotiate to include the two salespeople in the list of "Key Personnel" undermined OSI's argument that their resignations held material importance for the business.

Practical Implications

Although much of the Osram Sylvania decision turns on fact-specific allegations, the court's guidance on the interpretation of MACs may have wide application. In particular, the decision indicates that the omission of particular employees from lists of "Key Personnel" or "Key Employees" can be taken as prima facie evidence that those employees are not material enough to the company to cause a MAC if they resign. This can be rectified by either demanding a more expansive list of employees or stipulating that any combination of employees that accounts for a given percentage of the company's sales, revenues or other measure is deemed to be included in "Key Personnel."

The Osram Sylvania decision also apparently stands for the proposition that the resignation of salespeople, in particular among all employees, is less likely to cause a MAC under Delaware law, because the future performance of salespeople is speculative and uncertain. The solution for the buyer is again to make sure that the seller has listed all key salespeople, or combinations of salespeople, among those whose departures would be deemed a MAC.

Delaware Court of Chancery Analyzes Failure to Meet Projections and Loss of Key Salespeople as Triggers of MAC | Practical Law