by Effie D. Silva and Asra A. Chatham
When a potential buyer and seller disagree on how much a business is worth, an earn-out provision in the purchase agreement can help bridge the gap. An earn-out is a contingent payment tied to the performance of the acquired business or asset going forward. This payment structure can be advantageous to both the buyer and the seller. If the seller is confident that its business is worth more than what the buyer is willing to pay, the earn-out period gives it the chance to prove it. For buyers short on cash, an earn-out can provide a means of financing the transaction with future profits. While the earn-out structure can be appealing to both buyer and seller when closing the deal, these transactions can easily give way to litigation down the road if the agreement is not drafted with clarity and precision. If the business falls short of its earn-out target post-acquisition, selling shareholders may attempt to lay blame at the feet of the buyers, claiming that new management didn’t operate the business to achieve maximum profitability or that the buyer misrepresented its capabilities and resources. Typical claims in these disputes can include breach of contract, breach of the implied covenant of good faith, and fraudulent inducement.
Although Florida’s jurisprudence in the area of earn-out litigation is limited, courts can look to Delaware precedent when adjudicating earn-out disputes. Delaware courts offer a wealth of corporate merger litigation experience, and Florida courts frequently look to Delaware caselaw for guidance when construing analogous corporate doctrines under Florida law.1 The following cases represent the most recent and influential decisions in earn-out litigation that provide guidance for Florida dealmakers grappling with this rapidly expanding and contentious area of the law.
The Implied Covenant of Good Faith and Fair Dealing
In a typical earn-out agreement, a portion of the purchase price is contingent on the acquired company or asset achieving certain monetary or nonmonetary performance targets. When the business’ post-closing operations are left solely in the hands of the buyers, the parties may disagree on the extent of the buyers’ duty to ensure that the earn-out target is met. Even if the agreement does not explicitly require the buyer to take action in furtherance of achieving the earn-out target, seller-plaintiffs often argue that the implied covenant of good faith imposes this obligation. The implied covenant is inherent in all contracts governed by Florida and Delaware law and exists to fulfill the reasonable expectation of the parties that each will perform its contractual obligations in good faith.2 However, both Florida and Delaware courts look primarily to the plain language of the contract when resolving these disputes and consistently reject litigants’ attempts to use the implied covenant of good faith and fair dealing to rewrite agreements or impose extra-contractual obligations.
For example, in the Florida case of Meruelo v. Mark Andrew of the Palm Beaches, Ltd., 12 So. 3d 247 (Fla. 4th DCA 2009), a property owner sold a large parcel of land to developers planning to build a luxury condominium. The sale price included an additional $5 million post-closing payment to the seller in the event that the buyers were able to obtain approval of a site plan in excess of 600,000 square feet of air-conditioned, saleable space.3 When the buyers failed to seek such approval, the seller brought suit for the $5 million payment, claiming that the implied covenant imposed a duty on the buyers to make a good-faith effort to obtain approval.4 Florida’s Fourth District Court of Appeal rejected the seller’s claim and ruled in favor of the buyers.5 Because the parties’ agreement “did not expressly impose on the [b]uyers a duty to seek approval,” the court held that “there can be no implied duty to act in good faith in seeking such approval.”6
The Delaware courts have taken a similar approach. In Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126, 132 (Del. Ch. 2009), a pharmaceutical company entered into an asset purchase agreement providing that the seller, Squid Soap, would receive an earn-out payment if certain financial targets were met. However, after a harmful news report concerning Airborne’s flagship product, Airborne faced nationwide negative attention resulting in a number of widely publicized and financially damaging lawsuits.7 As a result of these unforeseen expenses, Airborne failed to market Squid Soap’s product, which ultimately led to Squid Soap’s failure to obtain the negotiated earn-out in the contract.8 Airborne sought a declaratory judgment that it was not liable for the earn-out payment under the asset purchase agreement, and Squid Soap counterclaimed for breach of contract and breach of the implied covenant of good faith and fair dealing.9 The Delaware Court of Chancery ruled in favor of Airborne. Because the plain language of the merger agreement did not obligate Airborne to take any particular actions to market Squid Soap, the court held that Airborne did not breach the contract.10 Furthermore, there was no breach of the implied covenant of good faith and fair dealing because Airborne’s failure to expend resources on Squid Soap was not arbitrary or in bad faith, but rather was the result of a corporate crisis.11 The court emphasized that Squid Soap had the right to insist on any specific contractual commitments at the time the agreement was made, but failed to do so.12 Because the implied covenant was not “a means to re-write agreements,”13 Squid Soap lost on both counts and failed to obtain the earn-out.
Similarly, in Winshall v. Viacom Int’l Inc., 76 A.3d 808, 816 (Del. 2013), the Delaware Supreme Court held that the implied covenant does not give the plaintiff contractual protections that it failed to secure for itself at the bargaining table. Viacom, a widely known entertainment company, entered into a merger agreement with Harmonix that provided for an earn-out based upon financial performance over a two-year period.14 In the second year, Viacom rejected an offer that would have reduced distribution costs for Harmonix, such that Harmonix would have been able to increase gross profits and attain the earn-out.15 After Harmonix failed to meet the earn-out targets, the selling shareholders brought suit alleging that Viacom had breached the implied covenant of good faith and fair dealing by turning down the offer.16 The selling shareholders argued that they had a reasonable expectation that Viacom and Harmonix would conduct themselves so as to maximize the amount of the earn-out.17 However, the court disagreed and found that there was no breach, stating that the implied covenant is not a “license to rewrite contractual language just because the plaintiff failed to negotiate for protections that in hindsight would make the contract a better deal.”18 Again, the court reasoned that the seller had every right to include a provision in the agreement requiring the buyer to conduct their business in a particular way, but failed to do so.19
Establishing Bad Faith
While both Florida and Delaware courts have made clear that they will not employ the implied covenant of good faith and fair dealing to rewrite the express terms of an earn-out agreement, sellers seeking to enforce earn-out provisions may still have a remedy if they are able to establish that the buyer acted arbitrarily or in bad faith. Under Florida law, when a contract confers discretion on one party, the party must exercise its discretion in good faith to protect the contracting parties’ reasonable commercial expectations.20 Likewise, Delaware’s Winshall court noted that the outcome in that case might have been different had the selling shareholders been able to show that Viacom “intentionally pushed revenue out of the earn-out period, or that they purposely shifted costs into the earn-out period in exchange for reduced costs in some future period.”21
Following this reasoning, in American Capital Acquisition Partners, LLC v. LPL Holdings, Inc., No. 8490-VCG, 2014 WL 354496, at *6-7 (Del. Ch. Feb. 3, 2014), the Delaware Chancery Court held that selling shareholders stated a claim for breach of the implied covenant based on allegations that the acquiring company (Concord-LPL) intentionally diverted resources to one of its subsidiaries (Fortigent) to avoid making an earn-out payment. The court specifically looked to the contingent purchase price provision in the stock purchase agreement, the compensation targets in the employment agreements, and the revenue calculation provision in order to determine the earn-out payments due to the selling shareholders.22 Taking these provisions together, the court held that “had the parties contemplated that the [d]efendants might affirmatively act to gut Concord-LPL to minimize [earn-out payments], the parties would have contracted to prevent LPL from shifting revenue from Concord-LPL to Fortigent.”23
Satisfying the element of intent presents its own challenges for plaintiffs attempting to recover earn-out payments under both express terms of the contract and the implied covenant. In Lazard Technology Partners, LLC v. Qinetiq North America Operations, LLC, 114 A.3d 193 (Del. 2015), a merger agreement prohibited the buyer from “taking any action to divert or defer revenue with the intent of reducing or limiting the [e]arn-[o]ut [p]ayment.” In order for the seller to recover for breach of this provision, the Delaware Supreme Court placed the burden on the seller to establish that the buyer’s action was “specifically motivated by a desire to avoid the earn-out,” rejecting the seller’s argument that it need only prove the buyer “knew [its] actions would reduce the likelihood that an earn-out would be due.”24 Nor could the seller rely on the implied covenant to avoid its contractual burden of proof “given the specificity of the merger agreement on that subject, and the negotiating history that showed that the seller had sought objective standards for limiting the buyer’s conduct but lost at the bargaining table.”25
Indeed, in the absence of clear standards governing the buyer’s post-acquisition conduct set forth in the parties’ agreement, it is unlikely that a seller would prevail on an implied covenant claim as long as the buyer can establish that its actions were commercially reasonable. Even when the implied covenant applies, Florida courts are unlikely to find a breach if the defendant can establish “good-faith business reasons” for its actions.26 Likewise, in Zhu v. Boston Scientific Corporation, No. 14-542-SLR, 2016 WL 1039487, at *5 (D. Del. Mar. 15, 2016), a federal district court applying Delaware law concluded that the buyer’s failure to develop a medical technology in a manner that would have allowed the sellers to receive earn-out payments did not constitute a breach of the implied covenant. The merger agreement at issue required the buyers to make several contingent payments to the sellers upon achieving specific milestones with respect to the technology’s regulatory approval and use in certain products.27 The agreement required the buyer to spend a minimum of $15 million “in connection with matters relating to” the products, but otherwise gave the buyer “sole discretion” in determining how to spend the $15 million.28 Further, the minimum spending obligation “would immediately cease” if the buyer “made a determination that further spending would not materially increase the level of feasibility of the [technology] and/or its commercial viability.”29
After the preliminary clinical trials were unsuccessful, the buyer elected to discontinue testing and development in accordance with the procedures set forth in the merger agreement.30 The sellers brought several claims against the buyers, including breach of the implied covenant.31 Consistent with Florida’s approach, the Zhu court recognized that “when a contract confers discretion on one party, the implied covenant requires to the discretion to be used reasonably and in good faith.”32 However, the court cited Winshall for the proposition that “it is not bad faith for a buyer to conduct its business in a commercially reasonable manner.”33 Because the sellers “simply disagreed with how [the buyers] chose to develop the [t]echnology,” the court held that there was no breach of the implied covenant.34
Fraud in the Inducement
Claims for fraud in the inducement also arise frequently in earn-out litigation, typically when the sellers allege that the buyers of the business or asset misrepresented their abilities or intentions to generate revenue sufficient to meet the earn-out target. In both Florida and Delaware, these claims often turn on whether the agreement includes an effective nonreliance provision. While Florida courts have struggled with the issue of what constitutes an effective contractual disclaimer for a fraud claim, Delaware precedent provides more concrete guidance.
In the Florida case of Lower Fees, Inc. v. Bankrate, Inc., 74 So. 3d 517, 518 (Fla. 4th DCA 2011), the seller of a technology platform, Lower Fees, sought to rescind a purchase agreement under which the buyer, Bankrate, had agreed to pay a percentage of future net revenues over a five-year period. During the negotiations for the sale, Bankrate orally represented that it had “extensive experience” with the technology.35 However, after completing the purchase, Bankrate’s chief executive officer admitted that Bankrate did not have any personnel capable of using the technology, and when it tried to merge the technology into its own platform, the Lower Fees system was destroyed.36 Lower Fees sought to rescind the agreement, claiming that Bankrate fraudulently induced Lower Fees into entering into the agreement based on Bankrate’s false representations that it had the expertise necessary to operate the system.37 Bankrate moved to dismiss the complaint on several grounds, one of which was that the contract included a provision stating that the parties were not relying on any representations outside of the agreement.38 However, the court applied longstanding Florida precedent to hold that Lower Fees’ fraud claim could proceed, stating that “no contract provision can preclude rescission on the basis of fraud in the inducement unless the contract provision explicitly states that fraud is not a ground for rescission.”39 Thus, “[i]f Bankrate wanted to contractually avoid a fraud claim,” the court reasoned, “it should have specifically stated that in the contract it signed.”40
Although Bankrate appears to be the only Florida case involving a claim for fraudulent inducement in the context of earn-out disputes, its precedential value may be limited. In 2016, Florida’s Fifth District Court of Appeal held in Billington v. Ginn-La Pine Island, Ltd., LLLP, 192 So. 3d 77, 79, 85 (Fla. 5th DCA 2016), that while a standard integration clause would not preclude a fraud claim, a “no reliance clause” accompanied by a waiver of claims arising from extra-contractual representations was sufficient to negate the plaintiff’s fraud claim. The Billington court distinguished Lower Fees “to the extent that the disclaimer language there did not contain a waiver.”41 However, Billington also disagreed with the Lower Fees court’s conclusion that a nonreliance clause, standing alone, does not negate a claim for fraud under Florida law.42 The Billington court explained that Florida courts have “struggled to reconcile and apply” Florida precedent regarding nonreliance provisions in the context of fraud claims and certified the question to the Florida Supreme Court for further clarification.43
The Delaware courts appear to follow the Billington court’s approach. For example, in the Squid Soap case, Delaware’s Court of Chancery held that the standard integration clause in the purchase agreement did not bar a claim for fraud in the inducement.44 Rather, “for 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 anti-reliance 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.”45 Under Delaware law, if a party promises in the contract “that it will not rely on promises and representations outside of the agreement,” it may not “shirk its own bargain in favor of a ‘but we did rely on those representations’ fraudulent inducement claim.”46
Delaware courts have applied these principles in several earn-out disputes. In the case of Haney v. Blackhawk Network Holdings, Inc., No. 10851-VCN, 2016 WL 769595, at *1 (Del. Ch. Feb. 26, 2016), the merger agreement included a performance-based earn-out payment of up to $50 million. The seller, CardLab, alleged that it agreed to this structure based in part on a contemplated contract with GameStop, which was projected to generate approximately $8.6 million.47 However, after the closing, CardLab learned that GameStop had an exclusivity agreement that would prevent it from selling, marketing, or distributing the buyer, Blackhawk’s, products such that CardLab would be unable to reach the earn-out target.48 CardLab brought a fraudulent inducement claim against Blackhawk, arguing that Blackhawk knew of the exclusivity provision and, thus, falsely represented that it expected the GameStop deal to proceed without delay.49 Because the merger agreement did not “contain express anti-reliance language,” the court held that it did not preclude CardStop’s fraud claims based on Blackhawk’s alleged extracontractual statements.50
In contrast, the courts in ITW Global Investments, Inc. v. American Industry Partners Capital Fund IV, L.P., No. N14-C-10-236 JRJ CCRD, 2015 WL 3970908, at *8 (Del. Jun. 24, 2015), and American Capital Acquisition Partners, each held that the plaintiffs’ fraudulent inducement claims based on extra-contractual statements were barred as a result of the anti-reliance clauses in the agreements. Because the agreements in these cases specifically warranted that the parties were not relying on representations made outside of the written agreements, plaintiffs could not state a cause of action for fraudulent inducement based upon such representations.51
Even if an earn-out plaintiff can point to a specific breach of the agreement or fraudulent conduct by the buyer, earn-out plaintiffs may face additional difficulties in proving causation. Specifically, the earn-out plaintiff must show that it would have met the earn-out targets, but for the defendant’s breach of contract or bad faith.
Earn-out plaintiffs wishing to avoid this pitfall may look to American Capital Acquisition Partners. In this case, the Court of Chancery held that the selling shareholders had adequately pled damages as a result of the breach based on allegations that they “forewent offers from other potential buyers for larger upfront payments.”52 Because the selling shareholders adequately alleged that “both parties anticipated that the transaction would generate large synergies,” the court could make a “reasonably conceivable inference” that “had the [d]efendants not interfered with Concord’s ability to generate revenue, it would have reached its revenue targets sufficient to trigger [the earn-out] payment….”53
Measuring the Earn-Out Target
Lack of precision and clarity in the agreement as to how the earn-out target is measured can also result in protracted litigation. In Vitality Systems, Inc. v. Sogeval Laboratories, Inc., No. 8:09-cv-200-T-24-EAJ, 2010 WL 1730784, at *4 (M.D. Fla. April 28, 2010), a Florida district court blamed the parties’ “ambiguous contractual language” for the “enormous confusion over how much money, if any” was due under the earn-out payment. Specifically, the parties’ “[f]ailure to specify clearly and explicitly” how the earn-out payment is calculated “gives rise to at least three reasonable possibilities.”54 The court determined that this ambiguity created a factual issue and accordingly denied the parties cross-motions for summary judgment.55
In contrast, the Delaware courts in Chambers v. Genessee & Wyoming, No. Civ.A.354., 2005 WL 2000765 (Del. Ch. Aug. 11, 2005), Comet Sys., Inc. S’holders’ Agent v. MIVA, Inc., 980 A.2d 1024 (Del. Ch. 2008), and Comet Systems v. MIVA were able to construe the plain language of the agreements to determine whether the earn-out target was met such that the cases could be resolved at an earlier phase in the litigation.56 In Chambers, the court determined that the agreement clearly set forth the method for calculating the earn-out, rejecting Genesee’s argument that the resulting calculation method would result in a windfall for Chambers.57 In Comet, the court likewise found that the agreement was unambiguous and clearly reflected the contracting parties’ intent as to how certain expenses were classified under the earn-out formula.58 The court concluded that the buyer had incorrectly calculated the earn-out, and the selling shareholders were entitled to the maximum payment.59
When structuring an earn-out provision, foresight, attention to detail, and precision are key. Disputes over entitlement to earn-out payments can be avoided (or at least, resolved in the earlier phases of litigation) if the parties identify their expectations in writing and with specificity. Post-closing obligations and operational standards should be set forth in detail. If possible, the parties should also include objective standards by which their performance can be measured and evaluated. Any facts or representations relied upon by either party should be stated explicitly in the agreement itself, and both parties should consider the effect and sufficiency of contractual disclaimers of liability. Finally, the parties should ensure that the formula for calculating the earn-out payment is easily discernible from the agreement itself and not subject to multiple interpretations. Adhering to these principles can help both buyers and sellers avoid a “doomed corporate romance” in favor of “a happy future filled with profits and growth.”60
1 See, e.g., Williams v. Stanford, 977 So. 2d 722, 727-28 (Fla. 1st DCA 2008) (looking to Delaware law to construe scope of Florida statute governing shareholder appraisal rights); Orlinsky v. Patraka, 971 So. 2d 796, 802-3 (Fla. 3d DCA 2007) (looking to Delaware law in action alleging majority shareholder’s breach of fiduciary duty); Naples Awning & Glass, Inc. v. Cirou, 358 So. 2d 211, 213-14 (Fla. 2d DCA 1978) (looking to Delaware law in an action to rescind stock purchase agreement under former Fla. Stat. §608.13(9)(b); Davidson v. Ecological Science Corp., 266 So. 2d 71 (Fla. 3d DCA 1972) (looking to Delaware law in action to inspect shareholder list under former Fla. Stat. §608.39(3)); see also Int’l Ins. Co. v. Johns, 874 F.2d 1447, 1459, n.22 (11th Cir. 1989) (“The Florida courts have relied upon Delaware corporate law to establish their own corporate doctrines.”).
2 See, e.g., Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126, 132 (Del. Ch. 2009); Cox v. CSX Intermodal, Inc., 732 So. 2d 1092, 1098 (Fla. 1st DCA 1999).
3 Meruelo, 12 So. 3d at 249.
5 Id. at 250.
6 Id. at 251.
7 Airborne Health, 984 A.2d at 134.
8 Id. at 135, 144.
9 Id. at 144, 145,148.
10 Id. at 145.
11 Id. at 147.
12 Id. at 146.
14 Winshall, 76 A.3d at 811.
15 Id. at 812.
16 Id. at 812-13.
17 Id. at 817.
18 Id. at 816 (quoting Dunlap v. State Farm Fire & Cas. Co., 878 A.2d 434, 442 (Del. 2005)).
20 Meruelo, 12 So. 3d at 251 (citing Snow v. Ruden, McClosky, Smith Schuster & Russell, P.A., 896 So. 2d 787, 791 (Fla. 2d DCA 2005)); Publix Super Markets, Inc. v. Wilder Corp. of Del., 876 So. 2d 652, 654-55 (Fla. 2d DCA 2004).
21 See Winshall, 55 A.3d at 639-40.
22 American Capital, 2014 WL 354496 at *7.
24 Lazard Technology Partners, 114 A.3d at 195 (Del. 2015).
25 Id. at 195-96. See also Haney v. Blackhawk Network Holdings, Inc., No. 10851-VCN, 2016 WL 769595, at *8-9 (Del. Ch. Feb. 26, 2016) (rejecting plaintiff’s claim for breach of the implied covenant because the agreement included specific requirements with respect to defendant’s post-closing obligations).
26 Cox v. CSX Intermodal, Inc., 732 So. 2d 1092, 1098; Publix Super Markets, Inc. v. Wilder Corp. of Del., 876 So. 2d 652, 655 (citing Sepe v. City of Safety Harbor, 761 So. 2d 1182, 1185 (Fla. 2d DCA 2000)).
27 Zhu, No. 14-542-SLR, 2016 WL 1039487 at *1.
28 Id. at *2.
30 Id. at *3.
31 Id. at *5.
32 Id. at *6.
35 Bankrate, 74 So. 3d at 518.
37 Id. at 518-19.
38 Id. at 520.
40 Id. at 520.
41 Billington, 192 So. 3d at 85.
43 Id. at 82, 85.
44 Airborne Health Inc., 984 A.2d at 141. For fraudulent inducement claims based on representations within the contract, however, Delaware courts generally will not enforce disclaimers of tort liability. See id. at 136-37.
45 Id. at 140; see also TEK Stainless Piping Prods., Inc. v. Smith, No. N13C-03-175 MMJ CCLD, 2013 WL 5755468, at *3-4 (Del. Oct. 14, 2013).
46 Abry Partners V, L.P. v. F & W Acquisition, LLC, 891 A.2d 1032, 1057 (Del. Ch. 2006).
47 Blackhawk Network Holdings, 2016 WL 769595 at *1, n.7.
48 Id. at *1-2.
49 Id. at *4-5.
50 Id. at *5-6.
51 ITW Global Investments, 2015 WL 3970908 at *8; American Capital, 2014 WL 354496 at *10.
52 Id. at *7.
54 Vitality Systems, 2010 WL 1730784 at *4.
55 Id. at *5.
56 Granting motion for summary judgment.
57 Chambers, 2005 WL 1730784 at *5-6.
58 Comet, 980 A.2d at 1030-1032.
59 Id. at 1032.
60 See LaPoint v. AmerisourceBergen Corp., No. Civ.A. 327-CC, 2007 WL 2565709, at *1 (Del. Ch. Sept. 4, 2007).
Effie D. Silva is an experienced trial partner with Duane Morris LLP in Miami. She focuses her practice on complex commercial litigation, international arbitration, health care, corporate fraud, and compliance matters for multinational and domestic corporations in various industries throughout the world, with an emphasis on Latin America.
Asra A. Chatham focuses her practice on product liability defense and complex commercial litigation. She serves as counsel for chemical manufacturers in national mass tort actions, defends putative class actions on behalf of managed-care clients, and has broad-based commercial litigation experience representing clients across a wide range of industries.
This column is submitted on behalf of the Business Law Section, Jon Polenberg, chair, and Stephanie C. Lieb, editor.