Delaware Chancery Court Provides Guidance on Prior Material Breach and Set-Offs
The Delaware Chancery Court recently reaffirmed several important contract interpretation principles in Post Holdings, Inc. v. NPE Seller Rep LLC, Civil Action No. 2017-0772-AGB. The case highlights the fact that a party claiming its contractual obligations were excused by a material breach by the other party may not seek or continue to receive any benefits under the contract after the alleged material breach. The court also clarified set-off rights under a stock purchase agreement.
A subsidiary of Post Holdings (Buyers) acquired all of the shares of National Pasteurized Eggs, Inc. (NPE) from NPE’s stockholders (Sellers) for $93.5 million in October 2016 pursuant to the terms of a stock purchase agreement. The stock purchase agreement provided for indemnification by the Sellers for all losses arising out of any inaccuracy or breach of representations and warranties made in or pursuant to the agreement. It also provided that the Buyers would remit tax refunds for the pre-closing period and certain business interruption insurance proceeds to the Sellers promptly after they were received. The stock purchase agreement also designated NPE Seller Rep LLC (NPE Seller) as the representative of all selling stockholders in connection with any disputes under the agreement.
In October 2017, the Buyers sued the Sellers and NPE Seller, as the sellers’ representative, alleging fraud and breach of representations and warranties in the stock purchase agreement. The Buyers had previously demanded indemnification and release of the $7.5 million escrow that had been set aside to satisfy any of the Sellers’ indemnification obligations. The Sellers had rejected this demand and subsequently submitted claims for indemnification to the Buyers, requesting payment of various state and federal tax refunds and insurance proceeds received by the Buyers. The Buyers refused to make payment.
NPE Seller then filed counterclaims seeking to recover approximately $974,000 in tax refunds and insurance proceeds to which the Sellers were entitled relating to the pre-closing period. NPE Seller moved for judgment on the pleadings on both of its counterclaims under Court of Chancery Rule 12(c).
In opposing NPE Seller’s motion, the Buyers relied on a theory of prior material breach of the stock purchase agreement by the Sellers. The Buyers argued that the post-closing obligation to remit the tax refunds and insurance proceeds in question were excused due to the Sellers’ material breach of the representations and warranties in the agreement which were made “as of the date of the Agreement and as of the Closing.” They also argued that the agreement allowed them to use a provision for netting obligations to allow them to apply the tax refunds to the amounts they deemed owed with respect to their indemnification claim.
In response, the Sellers argued that the Buyers could not simultaneously retain benefits under the stock purchase agreement – i.e. seek indemnification and release of the escrow – while also failing to perform their contractual obligations under such agreement.
The court agreed with the Sellers and granted judgment for the Sellers, finding that it is well settled “that a party may not refuse to perform its contractual obligations after a material breach while simultaneously retaining the benefits of a contract.” The court cited “Williston on Contracts” which explains that “[w]hen there has been a material failure of performance by one party to a contract … the [other] party has the choice to continue to perform under the contract or to cease to perform, and conduct indicating an intention to continue the contract in effect will constitute a conclusive election, in effect waiving the right to assert that the breach discharged any obligation to perform.”
Based on these principles, the court held that the Buyers could only condition their performance as a result of breach of the representations if the Buyers did not indicate an intent to continue to perform the contract by seeking benefits from the contract. By seeking indemnification and the funds in the escrow account, the court held that the Buyers had clearly indicated “an intention to continue the contract.” If the Buyers wanted to reap the benefits of the contract, they must continue to perform their obligations under the contract.
The court also rejected the Buyers’ argument that it could offset the tax liability against its claim for the $7.5 million equity. The court held that the plain language of the stock purchase agreement only allowed the Buyers to offset the amount that was actually owed to the Sellers. The court noted that the parties could have contracted to allow offset of a tax refund against an unliquidated indemnification claim, but did not do so. The parties limited the offset to payment that is “owed” which implies that it may only be offset against a “presently payable amount and not some uncertain amount that is contingent in nature.” The court found “there is no right to set-off of a possible unliquidated liability against a liquidated claim that is due and payable.”
In this case, the court was focused on the fact that the Buyers were seeking to excuse their own performance, while insisting on performance by the Sellers. They were not seeking to rescind or challenge the enforceability of the overall contract, but rather seeking to excuse their performance under one provision based upon the breach of an unrelated provision by the Sellers.
In such a context, a breach by one party to a contract will not relieve the other party from its obligation to perform if the party seeking relief also retains or seeks to retain the benefits of the contract. Therefore, parties to contracts should carefully consider the express terms of the agreement in determining their rights to withhold performance or unilaterally determine to offset obligations, particularly where such obligations have not matured or been finally determined.
One possible scenario that may have helped the Buyers in this case might have been to place the tax and insurance proceeds in an escrow account pending resolution of the fraud and misrepresentation claims. Once any liability of the Sellers had been finally determined and was actually owed, it is likely that the court would have allowed for an offset pursuant to the netting provisions of the agreement.