February 14, 2019

Earnouts: “Commercially Reasonable Efforts” Standard Keeps Claim Alive

Our old pal the earnout – everybody’s favorite way to bridge valuation gaps – found itself back in the Delaware Chancery Court again late last year.  In Himawan v. Cephalon,  (Del. Ch.; 12/18), the Court refused to dismiss claims premised on allegations that the buyer breached its obligations under an earnout provision in a merger agreement.

The seller was a biotech company & the earnout payments were tied to the buyer’s commercialization of two antibody-based disease treatments in development at the time of the deal. The buyer was obligated to use “commercially reasonable efforts” to develop the treatments – which the agreement defined to mean “the exercise of such efforts and commitment of such resources by a company with substantially the same resources and expertise as [Cephalon], with due regard to the nature of efforts and cost required for the undertaking at stake.”

While the buyer made milestone payments of $200 million for one of the treatments, it ultimately abandoned the other.  The plaintiffs sued, and the defendant moved to dismiss their breach of contract claim. This K&L Gates blog summarizes the Court’s decision to deny that motion. Here’s an excerpt:

Vice Chancellor Glasscock denied Cephalon’s motion to dismiss the breach of contract claim, recognizing in the decision that the merger agreement’s “commercially reasonable efforts” provision created an objective standard for evaluating Cephalon’s conduct. While indicating that potential alternative reasonable interpretations may be considered in construing Cephalon’s specific obligations under this standard, the court determined that this provision should not be held to be meaningless for purposes of ruling on a motion to dismiss for failure to state a claim.

The Court found that Ception’s former shareholders had sufficiently pled that Cephalon failed to comply with its obligations under this provision by alleging that similarly situated companies were pursuing treatments for the other identified condition. On the basis of this finding, the Court held that dismissing the breach of contract claim would be inappropriate.

The Vice Chancellor dismissed the plaintiffs allegations of breach of the implied covenant of good faith – reasoning that since the implied covenant was essentially a “gap filler,” its use was inappropriate when a contract contained an objective standard defining the nature of the obligations at issue.

Speaking of the implied covenant, the Delaware Supreme Court recently addressed it in its opinion in Oxbow Carbon & Minerals Holdings. v. Crestview-Oxbow Acquisition  (Del.; 1/19). Check out Francis PIleggi’s blog.on the decision.

John Jenkins