April 16, 2019

Earnouts: No Duty to Maximize Contingent Consideration

The Delaware Chancery Court recently held that a buyer was not under an obligation to maximize the amount of an earnout potentially payable to the sellers subsequent to an acquisition. In Glidepath Ltd. v. Beumer Corp., (Del. Ch. 2/19), Vice Chancellor Laster held that the buyer did not breach its contractual or fiduciary obligations by acting to maximize the company’s long-term value at the expense of short-term profits that would have resulted in higher earnout payments to the seller’s shareholders. Here’s an excerpt from this K&L Gates blog summarizing the case:

The Court rejected the Sellers’ claim that the Buyer violated the implied covenant of good faith and fair dealing by “taking action designed to frustrate the Sellers’ ability to receive the Contingent Consideration.” The Court noted that the implied covenant is best understood as a way of implying terms in an agreement to fill gaps in the agreement’s express provisions, and that the Sellers had not identified any gaps.

The Sellers also claimed that the Buyer breached its fiduciary duties. The Court agreed that the Buyer owed fiduciary duties, but held that those duties did not include an obligation to ensure that the Sellers received the Contingent Consideration. The Court found that the Buyer and its representative satisfied their fiduciary duty of loyalty, by acting in the best interests of their beneficiaries, and duty of care, by making decisions prudently and carefully. Fiduciary principles do not require that fiduciaries maximize the value of contractual claims. The Sellers had to rely on their contract rights and were not entitled to fiduciary protection.

The Court acknowledged that the Contingent Consideration obligations created a conflict of interest for the Buyer. By depressing the Company’s performance during the Earn Out Period, the Buyer could minimize the Contingent Consideration and benefit itself. Under Delaware law, a court applies the stringent “entire fairness” standard of care when analyzing conflicts of interest that might undermine a fiduciary’s ability to make disinterested and independent decisions. Under this test, the Buyer’s course of action in maximizing the long-term value of the Company needed to be objectively fair. The Buyer proved that it acted fairly by focusing on large-scale projects that maximized the value of the Company over the long term.

John Jenkins