Airborne Health, Inc. v. Squid Soap, LP, C.A. No. 4410 VCL Delaware Court of Chancery | Vice Chancellor Laster | November 23, 2009
This ruling by Vice Chancellor Laster of the Delaware Court of Chancery reminds us that in a commercial relationship, the contract reigns supreme. Even though it had a sympathetic story to tell, and despite some creative appeals to tort and equitable doctrines, Squid Soap couldn't get around the fact that the Asset Purchase Agreement (APA) it had negotiated with acquiror Airborne Health - with payment heavily weighted toward the earn-out - had not adequately protected it against certain unanticipated post-closing events that occurred, most notably the economic downturn.
Squid Soap had developed a child-friendly hand washing product. A hit with U.S. TV morning shows and major magazines, "Squid Soap" was soon picked up by Wal-Mart and other mass retailers. As the brainchild of a single entrepreneur, the Squid Soap business was ripe for a buyout. Despite interest from Procter & Gamble and a major hedge fund, Squid Soap selected Airborne Health, Inc., a larger entrepreneurial company, as its acquiror. Airborne had made its name with a highly successful vitamin and herb supplement that was marketed as effective against coughs and colds.
Small up-front payment, big earn-out
In 2007, Squid Soap and Airborne signed the APA. The deal - covering Squid Soap's brand name, goodwill, patents and other assets - paid only $1 million on closing but provided for earn-out payments of up to $26.5 million.
Assets to be returned if targets not met
The APA contained an Asset Return Provision (ARP), under which Airborne was required to return the assets to Squid Soap if certain marketing and sales targets weren't met. Squid Soap's idea was to give Airborne a shot while reserving the right to take its product back and try again with someone else if the specified marketing and sales targets were not met.
No specific "effort" requirements
Although the ARP specified service levels below which the assets would revert to Squid Soap, the APA did not include a standalone commitment from Airborne to invest a certain level of effort and money in the product. In other words, Squid Soap negotiated a mechanism for getting its assets back, but not (or at least not obviously) one that would require Airborne to put its muscle behind the product (and, by extension, protect the potential value of Squid Soap's earn-out).
How it all went wrong
Problems arose when Airborne's cold remedy claims came under scrutiny - first by ABC News and then by the Federal Trade Commission and various state authorities. There was also a class action in California that was eventually settled for $23.5 million plus a consumer rebate program. By this time, Squid Soap had been rebranded as "Squid Soap by Airborne" and the ensuing negative publicity, coupled with Airborne's failure to put its now strained resources behind the product, damaged the product's viability.
Product return rebuffed
In accordance with its interpretation of the APA, Airborne duly offered to return the assets to Squid Soap. But the company was not interested - possibly because it feared the loss of its potentially valuable earn-out in a changed economy where alternative investors were scarce (the value of the earn-out being especially significant in a potential litigation context). Instead, it claimed that Airborne had known full well about the problems, including the California litigation, when the deal was being negotiated.
The court proceeding
Rebuffed in its effort to apply the ARP, Airborne brought an action for specific performance and other equitable remedies, including a declaration that Squid Soap could not assert a claim against it. Squid Soap issued a defence and counterclaim, in response to which Airborne moved for summary judgment. Vice Chancellor Laster accordingly focused on Squid Soap's claims and whether - on a best-case scenario - any were potentially strong enough to preclude the issuance of the declaratory judgment requested by Airborne. The principal claims fell under the following headings:
- Fraud and fraudulent inducement;
- Extra-contractual misrepresentations;
- Breach of contract; and
- Breach of implied covenant of good faith and fair dealing.
In each case, as set out below, the court found that Squid Soap's arguments could not overcome the clear language of the APA.
Fraud and fraudulent inducement
Squid Soap's first claim was that Airborne's "no pending litigation" representation in the APA was fraudulent or a fraudulent inducement to enter into the contract. Under Abry Partners V, L.P. v. F&W Acquisition LLP, 891 A.2d 1032 (Del. Ch. 2006), a knowingly false contractual representation can ground an action in fraud. The problem for Squid Soap was that Airborne had represented only that:
There are no Legal Proceedings pending or, to the Knowledge of the Purchaser, threatened that are reasonably likely to prohibit or restrain the ability of Purchaser to enter into this Agreement or consummate the transactions contemplated hereby.
What made things worse was that Squid Soap's own "no pending litigation" representation in the APA was far stronger. Unlike the Airborne representation, it was not limited to proceedings that would interfere with closing. The court held that, given the wording, Squid Soap was out of luck: whatever proceedings might have been pending or likely at the time of the agreement clearly had not interfered with closing, "which appears to have gone off without a hitch". Nor did the court accept Squid Soap's arguments that "consummating the transactions" encompassed all the post-closing events contemplated by the parties, including earn-out payments. Not only did this contradict the ordinary understanding of "consummating the transactions" but it ignored the fact that the APA did not actually require Airborne to make any efforts or to pay out any earn-out payments (unless certain conditions were met).
To put it another way, the court essentially declined to write a MAE provision into the APA.
Squid Soap also alleged fraud with respect to extra-contractual misrepresentations. Airborne argued that the APA's integration (entire agreement) clause disclaimed reliance on extra-contractual representations. Vice Chancellor Laster rejected this argument because a standard integration clause does not suffice under Delaware law as a disclaimer of reliance. Moreover, the APA's exclusive remedy clause excepted "claims involving fraud or intentional misrepresentation" with no suggestion that the right being preserved was limited to claims founded on written representations in the contract - one of many drafting points to come out of the ruling.
Despite this small victory, Squid Soap's argument quickly foundered on its failure to plead any specific instance in which an actual misrepresentation had been made. Instead, it generalized about Airborne's alleged misrepresentations, concealments etc. The court commented:
[B]ecause the implications of a fraud claim are so significant, including its power to set aside contractual relationships that otherwise would be governed by the negotiated agreements between sophisticated parties, public policy requires a specific articulation of the statement that would have these effects.
The court would not permit the claim, or even permit Squid Soap's counsel to re-plead. A claim in "equitable fraud" also failed because no fiduciary relationship (or other "special equities") existed in what was a commercial relationship between sophisticated parties who were advised by well-known law firms.
Breach of contract
Squid Soap was no more successful with breach of contract. Among other things, it argued that Airborne had breached the APA by failing to market and promote Squid Soap. But, as already noted, the contract contained no such obligation. All that happened if Airborne didn't market the product was that it had to be returned to Squid Soap. Nor did the court accept Squid Soap's argument that Airborne had breached the APA by failing to return the assets as soon as the thresholds for retention were breached. Again, the contract provided only that "the Purchaser shall transfer the Purchased Assets existing as of such date (other than inventory) back to the Seller." - not that they had to be transferred on or by such date. The wording of this clause also scuppered Squid Soap's claim that Airborne had breached the agreement by (allegedly) dumping Squid Soap inventory into "mega-discount stores".
Good faith and fair dealing
Under Delaware law, a covenant of good faith and fair dealing is implied into all contracts. On this point, the key thing to remember, as Laster V.C. noted, quoting a previous ruling, is the following:
[T]he implied covenant only applies where a contract lacks specific language governing an issue and the obligation the court is asked to imply advances, and does not contradict, the purposes reflected in the express language of the contract. (Alliance Data Sys. Corp. v. Blackstone Capital Partners V L.P., 963 A.2d 746, 770 (Del. Ch. 2009), aff'd 976 A.2d 170 (Del. 2009))
It must be clear that the parties "would have agreed" to the covenant had they thought to address the issue in question. Laster V.C. observed that Delaware courts have tended to imply good faith and fair dealing cautiously.
In light of this interpretive background, Squid Soap's counsel characterized the absent "efforts" requirement as something that had simply not been addressed in the contract. As such, it would arguably be subject to the implication of a good faith/fair dealing covenant. Given the general purpose of the APA, counsel argued, it would surely have had to be understood as including some obligation on the part of the purchaser to "make an honest go of it." However, while Laster V.C. agreed that "Airborne.could not have refused arbitrarily or in bad faith to pursue the Squid Soap business", he pointed out that this wasn't actually what Squid Soap was alleging throughout the rest of its claim, where it had repeatedly insisted that Airborne had failed to promote the Squid Soap product not on an arbitrary basis but because of the corporate crisis caused by the California lawsuit and the FTC investigation.
Squid Soap's argument was further undercut, in the court's opinion, by the "ease with which [it] could have insisted on specific contractual commitments from Airborne regarding the expenditure of resources, or some form of 'efforts' obligation for Airborne." Squid Soap had instead contented itself with highly conditional earn-out terms. Laster V.C. noted, in concluding, that there was nothing necessarily "irrational" or "unreasonable" about this bargain: the APA simply loaded all of Squid Soap's downside protection into the ARP, presumably (i) because the quid pro quo of doing it this way was an enormous potential earn-out and (ii) because Squid Soap believed that it had a great product that could easily be shopped around again if, for whatever reason, things did not work out with Airborne.
Squid Soap may not have anticipated that problems with the acquiror's other business lines could affect the reputation of its soap product or (more significantly) that an asset return might occur under economic conditions that would make it difficult to find new financing for any product, even a good one. But, in the view of the court, none of this allows "Squid Soap to rewrite the deal it cut in more optimistic days." Laster V.C. accordingly issued declarations barring Squid Soap from litigating against Airborne anywhere other than in Delaware and stating that Airborne had fully complied with the APA. The court stopped short of issuing a decree of specific performance compelling Squid Soap to accept the return of the assets, apparently only because it appeared unlikely that Squid Soap would fail to do so.