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Court of Chancery Dismisses Challenge to Asset Purchase Agreement; Discusses Ramifications of Freedom of Contract in Purchase Agreement

Airborne Health, Inc. v. Squid Soap, LP, C.A. No. 4410-VCL (Del. Ch., November 23, 2009), read opinion here . A prior decision of the Court in this case was highlighted here.

In this Delaware Court of Chancery opinion, Vice Chancellor Laster granted defendants’ motion for judgment on the pleadings, dismissing numerous claims regarding an asset purchase agreement. Among other issues, the Court distinguished between an anti-reliance clause and an integration clause.

Background

Defendant Squid Soap, LP (“Squid Soap”) was created to fill a void in specialized child hand-washing products. When dispensed, Squid Soap would leave a small spot of ink on the skin that could only be removed by sufficient washing. John Lynn obtained three patents for the technology and soap dispenser (the “Patents”). In 2007, various investors, including Airborne Health, Inc. (“Airborne”), approached Lynn.

According to Squid Soap’s counterclaims, “[b]ased on Airbone’s representations about, among other things, its brand name, sterling reputation, marketing prowess, and in particular its promises to leverage the Airborne name and marketing platform to fully maximize Squid Soap’s potential, Squid Soap, relying on and induced by Airborne’s representations and promises, re-focused its acquisition talks to Airborne, to the exclusion of its other suitors.” Accordingly, on June 15, 2007, Airborne and Squid Scope entered into an Asset Purchase Agreement (the “APA”). Defendant Weil, Gotshal & Manges LLP (“Weil”) drafted and negotiated the APA on Airborne’s behalf. Through the APA, Airborne acquired all of Squid Soap’s assets.

APA and Four Unique Provisions

First, Squid Soap sold its assets for $1 million at closing with “the potential for earn-out payments of up to $26.5 million if certain targets were achieved.” The Court reasoned,

What an earn-out (and particularly a large one) typically reflects is disagreement over the value of the business that is bridged when the seller trades the certainty of less cash at closing for the prospect of more cash over time. In theory, the earn-out solves the disagreement over value by requiring the buyer to pay more only if the business proves that it is worth more. But since value is frequently debatable and the causes of underperformance equally so, an earn-out often converts today’s disagreement over price into tomorrow’s litigation over the outcome. Based on an earn-out of this magnitude (viewed in terms of the portion of total potential consideration), the plain inference is that Squid Soap believed that its business had tremendous value and was willing to bet heavily on that proposition.

Second, “Airborne purchased Squid Soap’s brand name, goodwill, and intellectual property, including the Patents, but the APA required that Airborne return the assets to Squid Soap if certain business targets were not met.” These “Asset Return Provisions” provided Airborne an opportunity to successfully market Squid Soap, but an opportunity to return the assets in the event Squid Soap was not successful. Specifically, if Airborne had not spent $1 million on marketing and achieved $5 million in net sales within one year, then Airborne was required to return the assets to Squid Soap. As the Court reasoned, “[l]ike the earn-out, this structure indicates that Squid Soap believed its product was a winner, that it was in demand, and that if Airborne could not make a go of it, then Squid Soap would get the assets back and could pursue a relationship with someone else.”

Third, the APA did not include any specific commitments by Airborne such as a mandatory commitment to spend certain levels of money on Squid Soap.

Fourth, the APA did not include representations by Airborne regarding its “positive brand name and image, its marketing power, . . . Airborne’s intent and . . . ability to market Squid Soap and to leverage Airborne’s positive image.”

Airborne’s Business Problems

At the time of the APA, Squid Soap claimed to be unaware of a special investigation conducted by ABC News regarding Airborne. In addition, Squid Soap claims that it was unaware of “a class action pending against Airborne in California state court, filed in May 2006, which asserted various claims for false or misleading advertising, consumer fraud, deceptive or unfair business practices, concealment, omission, and unfair competition.” Nine months after the APA was signed, Airborne settled the California Action for $23.5 million. Squid Soap alleges that Airborne knew of the California Action and the potential regulatory actions at the time the APA was executed.

The settlement shined the media spotlight on Airborne’s problems. More litigation resulted as the Federal Trade Commission and thirty-two states sued Airborne for false marketing. As a result, Airborne agreed to a collective $37 million in settlement fees and escrowed another $6.5 million for additional claims. Having been rebranded as “Squid Soap by Airborne,” Squid Soap alleged that Airborne’s financial struggles “killed Squid Soap in its infancy.”

Airborne Fails to Meet Benchmarks — Attempts to Return Assets

In light of its financial struggles, Airborne decided to shift its focus back to its traditional products, at the expense of promoting Squid Soap. Airborne, therefore, did not meet the financial thresholds of the Asset Return Provisions. Airborne attempted to return the assets, but Squid Soap refused to accept them.

Litigation Arises

Initially, Squid Soap sued Airborne in Texas, but that action was dismissed. Then, Airborne and Weil filed this action in the Court of Chancery seeking a declaratory judgment that they were not liable under the APA. Squid Soap counterclaimed against Airborne and Weil alleging 1) fraud and fraudulent inducement, 2) equitable fraud, 3) breach of contract, 4) breach of the implied covenant of good faith and fair dealing, and 5) as to Weil, aiding and abetting. Airborne and Weil moved for judgment on the pleadings. Squid Soap alleged that Airborne “fraudulently induced Squid Soap to enter into the APA by representing false statements as true, actively concealing facts, and/or failing to disclose material facts.”

Fraud Claim Based on Airborne’s Contractual Misrepresentation

Squid Soap alleges that Airborne committed fraud by making a contractual misrepresentation in that Airborne intentionally concealed and failed to disclose the various litigations and investigations involving Airborne. The Court reasoned that “[b]ecause of Delaware’s strong public policy against intentional fraud, a knowingly false contractual representation can form the basis for a fraud claim, regardless of the degree to which the agreement purports to disclaim or eliminate tort remedies.”

However, the Court noted that “[t]he plain language of Airborne’s representation obligated Airborne to disclose any ‘Legal Proceedings’ that were (1) ‘reasonably likely to prohibit or restrain the ability of [Airborne] to enter into this Agreement’ or (2) ‘reasonably likely to prohibit or restrain the ability of [Airborne] to . . . consummate the transactions contemplated hereby.’” The Court held that it was undisputed that there was no litigation threatened or pending as of the date of the APA that was “reasonably likely to prohibit or restrain the ability of [Airborne]” to close the deal. As a result, the Court found that Airborne’s representation was accurate and entered judgment on the pleadings in favor of Airborne on Squid Soap’s contract-based fraud claim.

Fraud Based on Airborne’s Extra-Contractual Misrepresentations

In addition, “Squid Soap contends that Airborne committed fraud by making extra- contractual representations, actively concealing facts, and failing to disclose material facts.” The Court’s analysis hinged on “whether the APA bars Squid Soap’s right to assert fraud claims based on extra-contractual representations.” As the Court reasoned,

An anti-reliance provision must be explicit, and a standard integration clause is not enough. . . . [F]or a contract to bar a fraud in the inducement claim, the contract must contain language that, when read together, can be said to add up to a clear antireliance clause by which the plaintiff has contractually promised that it did not rely upon statements outside the contract’s four corners in deciding to sign the contract. The presence of a standard integration clause alone, which does not contain explicit anti-reliance representations and which is not accompanied by other contractual provisions demonstrating with clarity that the plaintiff had agreed that it was not relying on facts outside the contract, will not suffice to bar fraud claims.

The Court found that the APA did not contain any anti-reliance language or any other provision that would limit Squid Soap’s ability to assert a common law fraud claim or fraud-in-the-inducement claim. Instead of disclaiming reliance, the APA defined the parties’ contract. “When drafters specifically preserve the right to assert fraud claims, they must say so if they intend to limit that right to claims based on written representations in the contract. [The Court] will not imply that limitation.”

As to the substance of the claim, the Court defined the “core test’ as “whether the claim has been pled ‘with detail sufficient to apprise the defendant of the basis for the claim.’” Lacking that detail, Squid Soap’s “generalized and non-specific” allegations did not “identify any specific fact that was misrepresented and they do not mention any person or the time, place, or contents of the misrepresentation.” While Squid Soap claimed that without discovery it could not provide more detail, the Court disagreed. A party who alleges fraud “should be able to say when he was lied to, or what specifically was said to him that was materially misleading by the omission. The lack of prior discovery poses no impediment to a plaintiff’s ability to plead ‘the circumstances constituting fraud.’ After all, the plaintiff was there.” Accordingly, Airborne’s motion for judgment on the pleadings was granted in favor of Airborne on Squid Soap’s claim of extra-contractual fraud and fraudulent inducement.

Equitable Fraud

As an alternative to common law fraud, Squid Soap alleged that it should recover under equitable fraud. As the Court reasoned, equitable fraud is both separate and broader than common law fraud. The Court stated that “[f]raud in equity includes all willful or intentional acts, omissions, and concealments which involve a breach in either legal or equitable duty, trust, or confidence, and are injurious to another, or by which an undue or unconscientious advantage over another is obtained.”

However, equitable fraud “requires special equities, typically the existence of some form of fiduciary relationship . . . .” Because the parties lacked such a relationship, and instead contracted at arms length, judgment was entered in Airborne’s favor.

Breach of Contract

Next, “Squid Soap contends that Airborne breached the APA “by making false representations about its marketing abilities and prowess, by failing to disclose the [California] Action and other litigation, and by failing to market and promote Squid Soap’s products as promised and required by the APA.” As to the false representations, the Court held that there were no representations in the APA about Airborne’s “marketing abilities and prowess.” As to the failed disclosures, this was akin to the contractual fraud claim that was previously dismissed. As to the failed marketing and promotional efforts, the Court reasoned that the APA did not contain any requirements that Airborne spend certain amounts or take certain actions. Accordingly, the motion was entered in Airborne’s favor on the breach of contract claim.

Implied Covenant of Good Faith and Fair Dealing

The Court also granted Airborne’s motion for judgment on the pleadings as to Squid Soap’s claim for breach of the implied covenant of good faith and fair dealing. The Court stated that “[t]he test for the implied covenant depends on whether it is ‘clear from what was expressly agreed upon that the parties who negotiated the express terms of the contract would have agreed to proscribe the act later complained of as a breach of the implied covenant of good faith—had they thought to negotiate with respect to that matter.’” Because the APA provides a specific representation for Airborne with respect to litigation disclosure, the implied covenant claim failed. While Squid Soap should have negotiated for broader representations, it did not and “the implied covenant is not a means to re-write agreements.”

Aiding and Abetting Against Weil

As the Court found no underlying wrong, judgment was entered in Weil’s favor.

Airborne and Weil’s Claims

In summary fashion, the Court addressed Plaintiffs’ claims and found that two issues were not suitable for disposition on the present record — a claim for specific performance under the Asset Return Provision and a claim for damages for breach of the APA.

This summary was prepared by Kevin F. Brady and Ryan P. Newell.

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