There’s an old saying – “Sticks and stones may break my bones, but words will never hurt me.” While this mantra may help bruised egos on the playground, it’s of no use in M&A disputes. Three recent Delaware Court of Chancery rulings on earnout disputes demonstrate that the contractual post-closing obligations of the buyer (along with specific facts) may be outcome determinative in earnout litigation. In both Fortis v. Johnson & Johnson (Del. Ch., September 2024) and SRS v. Alexion Pharmaceuticals (Del. Ch., September 2024), the Delaware Chancery Courts found buyers liable for failure to comply with negotiated earnout covenants – and in the latter case, awarded the plaintiffs more than $1 billion in damages. On the other hand, in Fortis v. Medtronic Minimed (Del. Ch., July 2024), buyer-friendly covenants enabled the buyer to prevail in an earnout dispute. These cases also offer a peek behind the curtain of fact-finding, laying bare the complicated nature of these disputes.[1]
Earnouts play a particularly key role in life sciences transactions. According to SRS Acquiom’s 2023 Life Sciences M&A Study, 91% of private bio/pharma deals, 59% of private medical device deals, and 47% of private diagnostics and research technologies deals in the study included an earnout between 2021 and 2023. Comparatively, just 21% of non-life sciences deals included an earnout in the same period. Further, the size of earnouts in life sciences transactions is substantial, representing 61% of total consideration in private bio/pharma deals, 19% of total consideration in private medical device deals, and 33% of total consideration in private diagnostics and research technologies deals, according to the same study.
The frequency and size of earnouts makes them ripe for dispute. Sellers may view the achievement of certain near-term milestones as “in the bag” and become disgruntled if the milestones are not achieved. Conversely, buyers want to maintain flexibility on development and commercial decisions they make after closing and do not want to pay for value not received. This dynamic has increased the number of earnout/milestone disputes and is influencing how earnout provisions are negotiated in acquisition agreements.
In this post, we recap the unique facts of each case, the negotiated efforts covenant and key takeaways.
Bespoke earnout provision pokes buyer
The Delaware Chancery Court’s post-trial memorandum opinion in Fortis v. Johnson & Johnson made headlines because J&J was held liable for more than $1 billion in damages. In its opinion, the court held that J&J breached its obligations in the merger agreement and the implied covenant of good faith and fair dealing regarding the iPlatform regulatory milestones, but not certain other regulatory milestones or net sales milestones.
Transaction background
Auris Health was a venture-backed startup that had developed two novel surgical robots: Monarch, being developed for endoscopic procedures, and iPlatform, being initially developed for laparoscopic surgery with a view to expand use to endoscopic surgery. J&J was attempting to develop its own surgical robot – Verb – but the development was plagued by problems in the design process and was significantly behind schedule for a publicly announced 2020 launch date. J&J became interested in Auris’ Monarch technology and invested in Auris’ Series D financing. After gaining access to information about iPlatform, J&J began to worry what iPlatform could do to Verb’s success. By July 2018, J&J began considering an acquisition of Auris to have iPlatform as a backup plan for Verb. After lengthy negotiations, a J&J entity and Auris entered into a merger agreement in February 2019, with J&J agreeing to pay $3.4 billion up front in cash and up to $2.35 billion in cash upon the achievement of eight regulatory milestones and two commercial net sales milestones. At the time the merger agreement was signed, the court states, “Auris had a high level of confidence in achieving regulatory clearance via the 510(k) platform, in iPlatform’s and Monarch’s ability to deliver on the milestones and a shared vision with J&J for the robots.”
Efforts covenant
The merger agreement required J&J to devote commercially reasonable efforts in furtherance of each of the regulatory milestones. J&J’s efforts were required to be consistent with its “usual practices” for a “priority medical device,” and J&J was prohibited from taking into account the cost of milestone payments in making any commercially reasonable development decisions. The court noted that the merger agreement did not contain language granting J&J complete discretion over decisions relating to the Auris business following the closing.
Key factual findings
Shortly after closing, J&J pitted iPlatform and Verb against each other in “Project Manhattan” for a competitive assessment of both robots involving a series of in-house surgical challenges. More than 80 Auris personnel were diverted from progressing development of iPlatform required to satisfy the earnout milestones to instead do work to stabilize iPlatform’s alpha robot in order to face the post-beta Verb robot in Project Manhattan. Project Manhattan also involved surgical procedures that were more advanced than those needed for iPlatform to satisfy the regulatory milestones in the merger agreement.
Ultimately, J&J decided that iPlatform was the better bet, but the competition caused “needless setbacks and resources drains” that impacted the development timeline, and J&J required that Verb’s hardware team be integrated with the iPlatform team, which the court found further hampered iPlatform’s launch and milestone achievement. J&J also required iPlatform to pursue a more complex five-arm surgical procedure for its first regulatory clearance, putting off achievement of the general surgery milestone by the 2021 deadline in the merger agreement. Additionally, J&J wrote down to zero certain of the regulatory milestones for accounting purposes, modified employee incentives to be inconsistent with achieving the milestones in the merger agreement, and communicated to employees that the milestones were “canceled” –which impacted the former Auris employees’ motivation to achieve the milestones.
Ruling
The court found that J&J deliberately impaired iPlatform’s development to benefit its competing Verb device. J&J knew Project Manhattan would hinder – rather than promote – iPlatform’s achievement of the regulatory milestones. As a result, the court awarded damages equal to certain of the missed milestones plus interest.
Outward-facing efforts standard puts buyer on the outs
The most recent earnout decision by the Delaware Chancery Court, in SRS v. Alexion Pharmaceuticals, arose out of Alexion’s 2018 acquisition of a company called Syntimmune. Alexion was found liable for breach of contract, both for its failure to use commercially reasonable efforts to achieve milestones and for its failure to pay an earned milestone payment to selling securityholders of Syntimmune.
Transaction background
Alexion acquired Syntimmune for a total purchase price of $1.2 billion, $400 million of which was paid up front, with up to $800 million in milestones. Each milestone was tied to a stage of further development of Syntimmune’s monoclonal antibody, ALXN1830. The first milestone was a “$130 million payment upon the completion of a successful Phase 1 Clinical Study.” The successful completion of a phase 1 clinical study was further defined to be the satisfaction of five specifically negotiated technical criteria.
Efforts covenant
The merger agreement required Alexion to use commercially reasonable efforts to achieve each milestone for seven years after closing of the transaction. The merger agreement used an “outward-facing” or “objective” definition of commercially reasonable efforts, under which Alexion’s efforts were measured by what a hypothetical, similarly situated company to Alexion would do under the circumstances.
Key factual findings
Following the acquisition, the ALXN1830 program encountered a number of challenges, including contamination of its drug supply and pause of ongoing trials due to the COVID-19 pandemic. As pandemic restrictions eased, Alexion deprioritized development of ALXN1830 in favor of shifting its resources toward other Alexion programs as part of a corporate goal to launch 10 products by 2023. While Alexion did not fully pause development of ALXN1830, development fell behind competitive programs.
Later, Alexion was acquired by AstraZeneca in a transaction that contemplated achieving approximately $500 million in recurring synergies in the combination. As a result of the acquisition, all of Alexion’s programs came under review, including ALXN1830. During the same time, additional data from a phase 1 trial of ALXN1830 began to suggest certain safety risks, but was inconclusive. Based on a number of factors – including potential safety risks and the product’s expected order of market entry relative to competitive products – Alexion terminated the program.
Ruling
The court applied a “hypothetical company” approach and measured Alexion’s effort against that of a “hypothetical typical company of Alexion’s size, working on a molecule like ALXN1830 at a similar stage of development, considering the factors such a company would typically consider, up until the point of being contrary to prudent business judgment.” The court determined that Alexion’s “deprioritization” actions in 2020 did not rise to “commercially reasonable efforts,” because that decision was driven by an idiosyncratic corporate initiative to launch 10 products by 2023, and a hypothetical company would not have otherwise defunded a product like ALXN1830. The court noted that Alexion’s competitors were all moving forward with the development of competing therapies during that time.
With respect to safety, the court said that the data raising potential safety concerns was inconclusive, and a hypothetical company would have responded by gathering further data, instead of terminating the program outright. As for projected timing of market entry, the court noted that internal Alexion records indicated that ALXN1830 would still be the first to market for at least two indications being pursued. Following consideration of these and other factors, the court found that Alexion failed to use commercially reasonable efforts to try to meet the milestones laid out in the merger agreement and awarded damages.
‘Sole and absolute discretion’ protects buyer from earnout liability
In Fortis v. Medtronic Minimed, the Delaware Chancery Court dismissed claims by the sellers’ representative that the buyer wrongfully deprived the target’s former stockholders of a $100 million contingent milestone payment. The court rejected the plaintiff’s claims based on the earnout provision’s buyer-friendly language concerning the buyer’s obligations with respect to achievement of the milestone.
Transaction background
Companion had developed two “smart insulin pen” products, which were particularly interesting to Medtronic because it operated a diabetes unit for its parent company. In 2020, Medtronic acquired Companion, and the merger agreement required Medtronic to make milestone payments if Medtronic sold at least 85,000 smart insulin pens for an average price of at least $400 each during any four consecutive quarters of the full eight quarters following the closing. The post-closing sales did not meet the milestone threshold, and Medtronic did not pay the milestone payment.
Key plaintiff allegations
The plaintiff made a number of allegations in its claim that Medtronic acted with the primary purpose of avoiding the payment of the earnout – including imposing employment terms that led to the exodus of Companion’s top salespeople, failing to replace departed salespeople, not incentivizing Medtronic’s sales team to sell Companion products, deferring commencement of a marketing program that had been discussed by the parties prior to signing the merger agreement, and refusing to pursue certain regulatory clearances that could have expanded sales opportunities.
Efforts covenant
The merger agreement did not contain an affirmative obligation for the buyer to use commercially reasonable efforts to achieve the milestone or to act in good faith. Instead, the merger agreement provided that the buyer could not “take any action intended for the primary purpose of frustrating the payment of Milestone Consideration.” The merger agreement further provided that “development, marketing, commercial exploitation and sale of the Milestone Products” could be exercised by the buyer in its “sole and absolute discretion,” and that the buyer would not “have any liability whatsoever to any [former target stockholder] for any claim, loss or damage of any nature that arises out of or relates in any way to any decisions or actions affecting whether or not or the extent to which the Milestone Consideration becomes payable.”
Ruling
The court concluded that “[d]eferring action and refusing action are functional opposites of ‘tak[ing]’ action,” and that the allegations could not support a claim that the buyer had taken an action intended for the primary purpose of frustrating the payment of Milestone Consideration. If the buyer had covenanted to use reasonable efforts to achieve the milestone, the court said that those omissions might have carried more weight. The court observed that the language in the contract put the plaintiff in the position of having to satisfy a pleading burden that it just could not meet because it lacked evidence of specific actions taken for the “primary purpose” of frustrating the milestones. The court concluded that Medtronic secured for itself sole discretion to take actions that Medtronic knew would frustrate achievement of the first milestone, so long as the actions had some other primary purpose.
Key takeaways
- Circumstances change but negotiated language does not – These recent decisions illustrate the importance of the efforts standards negotiated in the merger agreement on the likelihood of prevailing in an earnout dispute. The outcome of negotiating these critical provisions of a merger agreement is likely to turn on the relative negotiating leverage of the parties in the particular transaction.
- Complications with outward-facing standards – An outward-facing commercially reasonable efforts standard is viewed generally as being a more objective standard, but it may create uncertainty for a buyer in the event of a dispute. In an earnout dispute, a court will have the leeway to decide appropriate comparisons and judge the buyer’s actions with the benefit of hindsight.
- Consider specifying post-closing plans – If the parties are contemplating an inward-facing commercially reasonable efforts standard, the parties may want to consider whether to include more specific requirements, rather than relying on a typical reference to how the buyer develops, launches and commercializes products with similar market potential and all of the factors the buyer can take into account in making those decisions. Further, the parties should consider whether the economic impact of the potential milestone payments can be taken into account by the buyer in making decisions.
- Access to earnout information – Sellers should keep in mind that following a closing, the stockholder representatives’ insights into the buyer’s actions or omissions may be limited to the buyer’s sanitized periodic reports on their efforts to achieve the milestones. The plaintiffs in the J&J case had the advantage of a carryover workforce that had knowledge of the actions taken by J&J, but often the buyer does not retain the target’s employees to complete the product development or commercialization of products.
- Impact of acquisition on earnout obligations – Buyers that acquire targets that have outstanding earnout obligations from prior acquisitions need to consider how to conduct due diligence on the target’s compliance (or lack thereof) with commercially reasonable efforts obligations and should not assume that, post-closing, they can eliminate the target’s encumbered programs based on their own standard decision-making process.
[1] The opinion in Fortis v. Johnson & Johnson states that the findings of fact include the testimony of 23 fact and nine expert witnesses over 10 trial days, 78 deposition transcripts and 6,209 joint fact exhibits.
