Two recent cases in the M&A space regarding earn-outs make one thing clear: express language in the definitive agreement prevails over any implied covenant of good faith and fair dealing.

Fortis Advisors LLC v. Dialog Semiconductor PLC  (Del. Ch. January 30, 2015) (granting a buyer’s motion to dismiss a claim for breach of the implied covenant of good faith and fair dealing where the merger agreement left no room for implication of additional terms regarding earn-out)

The Court confirmed that, in order to state a claim for breach of the implied covenant of good faith and fair dealing, there must be a gap in the agreement for the implied covenant to operate.  “[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.”  In this action involving a dispute over whether earn-out payments were owed to plaintiff (seller) in connection with a merger transaction, the court did not hesitate to dismiss Plaintiff’s claim for breach of the implied covenant, noting that plaintiff “admits it does not believe that any gaps exist in the merger agreement from which to imply an additional contractual term.”  The merger agreement contained a specific provision addressing earn-out payments, requiring that buyer use its “commercially reasonable best efforts . . . to achieve and pay the Earn-Out Payments in full,” and provided certain detailed obligations and prohibitions (quoted below) concerning the buyer’s operation of the business post-close:

“. . . (i) Parent shall, and shall cause its Affiliates . . . to (A) operate the business of the Surviving Corporation and its Subsidiaries as a separate, stand-alone business unit (understanding that Parent may elect to integrate sales, service, supply chain and administrative functions with those of Parent), (B) maintain a separate research and development organization within such business unit with engineering headcount at a level not materially below that currently maintained by the Company and (C) price the products of the Surviving Corporation on a standalone basis and without any reduction related to the pricing of products by Parent’s other product lines and (ii) Parent shall not, and shall not authorize or permit its Affiliates . . . to, (A) take any action with the intent of avoiding or reducing the payment of any Earn-Out Payment, (B) divert to another business of Parent any business opportunity in a manner that could reasonably be expected to or does diminish or minimize the Earn-Out Payments, (C) take any action for the purpose of shifting Revenue outside of the Earn-Out Periods . . . or reducing Revenue . . .”

In dismissing the claim for breach of the implied covenant, the Court found that it did not need to reach the question of whether buyer actually breached the provisions of the merger agreement. The Court found that because the merger agreement directly addressed the issue in dispute, “implied good faith [could] not be used to circumvent the parties’ bargain.” As the Court held,

“In my opinion, the allegations of the complaint fail to state a claim for breach of the implied covenant because Fortis has not identified, as it must, a gap in the Merger Agreement to be filled by implying terms through the implied covenant.  Stated differently, Fortis has failed to identify any implied contract term that it would have this Court read into the Merger Agreement.”

Lazard Technology Partners, LLC v. Qinetiq North America Operations LLC (Del. April 23, 2015) (affirming the dismissal of a seller’s claim for breach of the implied covenant of good faith and fair dealing and of the earn-out provision of the merger agreement, focusing on the primacy of the agreement’s plain language)

This appeal to the Delaware Supreme Court arose from a dispute over earn-out payments following a merger, where the seller argued that the buyer breached both the merger agreement and the implied covenant of good faith and fair dealing by failing to take certain actions that the seller contended would have generated an earn-out payment.  As in Fortis above, the Court placed great weight on the explicit language of the merger agreement, which specifically “prohibited the buyer from ‘tak[ing] any action to divert or defer [revenue] with the intent of reducing or limiting the Earn-Out Payment’” (emphasis added).  The Court of Chancery concluded, with respect to the breach of contract claim, that “the merger agreement meant what it said”: in order for buyer to have breached Section 5.4 (the earn-out provision), it must have acted with the “intent” to reduce or limit the earn-out payment, and seller had not proven that any business decision of the buyer was motivated thereby.  Rejecting the seller’s argument on appeal for a knowledge standard (namely, that Section 5.4 precluded any conduct by the buyer that it knew would have the effect of compromising the seller’s ability to receive an earn-out), the Delaware Supreme Court held as follows:

“The Court of Chancery acted properly in giving Section 5.4 its plain meaning.  By its unambiguous terms, that term only limited the buyer from taking action intended to reduce or limit an earn-out payment.  Intent is a well-understood concept that the Court of Chancery properly applied . . . As Section 5.4 is written, it only barred the buyer from taking action specifically motivated by a desire to avoid the earn-out.”

As the Court clarified, the Court of Chancery “never said that avoiding the earn-out had to be the buyer’s sole intent, but properly held that the buyer’s action had to be motivated at least in part by that intention.”

Unsurprisingly, the Court also rejected seller’s argument that the buyer violated the implied covenant of good faith and fair dealing.  Without reaching “the buyer’s well-reasoned argument that Section 5.4 addressed the full range of discretionary conduct relevant to the earn-out calculation, leaving no room for the implied covenant to operate at all,” the Court affirmed the Court of Chancery’s holding that “the implied covenant did not inhibit the buyer’s conduct unless the buyer acted with the intent to deprive the seller of an earn-out payment,” which the Court found the buyer had not done.  The Court went on to note the generosity of the lower court in “assuming that the implied covenant of good faith and fair dealing operated at all as to decisions affecting the earn-out, given the specificity of the merger agreement on that subject,” and made clear that “Section 5.4 specifically addressed the requirements for an earn-out payment and left the buyer free to conduct its business post-closing in any way it chose so long as it did not act with the intent to reduce or limit the earn-out payment.”

Posted by CooleyM&A