In Chicago Bridge & Iron Co. N.V. v. Westinghouse Electric Co. LLC, the Delaware Court of Chancery declined to permit the purchaser of a business to recover a working capital shortfall as a result of a purchase price adjustment because of a contractual limitation. The Court of Chancery has rendered another decision precluding a working capital recovery in Sparton Corp. v. O’Neil.

The merger agreement was negotiated and executed on behalf of the stockholders and optionholders of target Hunter Technology Corporation by a representative (the “Equity Representative”). Hunter was the sole party to make representations and warranties in the merger agreement to purchaser Sparton. In the merger agreement, Hunter represented its financial statements were prepared in accordance with GAAP. Sparton disclaimed reliance on any other representations and warranties related to Hunter that were not included in the merger agreement.

The merger agreement provided for a preclosing estimate of an “Allocable Amount” which included working capital, with a subsequent true up of the Allocable Amount. While the stockholders and optionholders of Hunter agreed to indemnify Sparton for breaches of representations and warranties, including those related to the financial statements, the indemnification provision precluded recovery for any loss included in the calculation of the final Allocable Amount, except in the case of fraud. Based in part on the alleged oral representations of the Equity Representative, the parties agreed that the working capital adjustment was capped at $750,000 and that was the exclusive remedy for any overstatement of working capital, except in the case of fraud. A working capital escrow of like amount was also established.

Sparton alleged before the working capital estimate was calculated the Equity Representative and others artificially overstated the value of Hunter’s accounts by, among other things, adding amounts to invoices that were not owed and invoicing customers for work that had not yet been completed. Sparton also alleged that before closing the Equity Representative and others caused Hunter to write off the overstated amounts causing Hunter’s working capital to revert to its actual, lower value. Sparton claimed that as a result it overpaid for Hunter’s working capital by $2,579,455.

Following Closing, Sparton presented the Equity Representative with its post-closing working capital adjustments of $2,579,455. The Equity Representative did not dispute the amount and released the $750,000 working capital escrow to Sparton. To mitigate its damages, Sparton requested an additional $550,000 from a separate indemnity escrow which the Equity Representative declined.

Sparton sued to recover its losses. The defendant stockholders and optionholders moved to dismiss. Sparton did not dispute the applicability of the contractual limitations but argued its claim should survive the motion to dismiss because the contract was fraudulently induced and therefore any contractual limitations did not apply. The Court noted that Delaware honors disclaimers on extra-contractual representations and that Sparton could not rely on any extra-contractual representations made by the Equity Representatives or others.

The Court noted that the stockholders and optionholders did not agree to indemnify for any losses resulting from Hunter’s misrepresentations to the extent the loss was included in the Allocable Amount, except in the case of fraud. For Sparton to state claim for fraud, Sparton must plead the circumstances constituting the fraud with particularity under Court of Chancery Rule 9(b), while knowledge may be averred generally. To satisfy Rule 9(b), a complaint must allege: (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 representations.

The Court of Chancery held Sparton did not satisfy the pleading standards for fraud. Some of the reasons cited by the Court include:

  • The complaint does not identify who specifically did what or how they “assisted” in allegedly misstating the invoices or financial statements.
  • Sparton did not specify the invoices at issue or the amounts by which they were doctored.
  • The knowledge requirement was not met because none of the stockholders or optionholders personally represented anything about the accuracy of the financial statements, signaling they were not in a position to know the veracity of the statements.