February 20, 2020

Earnouts: Court Rejects Claim Based on Conduct of Business Covenant

A recent Delaware Superior Court decision provides some insight into how courts interpret contractual limitations on a buyer’s right to manage the post-closing conduct of the business when an earnout is at stake. In Quarum v. Mitchell International, (Del. Supr.; 1/20), the Court rejected a plaintiff’s claim that the defendant’s failure to take certain actions breached obligations set forth in an earnout agreement.  The language at issue is highlighted below:

(a) The Sellers acknowledge and agree that [Mitchell] as the ultimate owner of [QMedtrix] from Closing, has the power to direct the management, strategy and decisions of [QMedtrix].  Notwithstanding the foregoing, [Mitchell] agrees that it will, and that it will cause [QMedtrix] to and its affiliates to act in good faith and in a commercially reasonable manner to avoid taking actions that would reasonably be expected to materially reduce the Contingent Payment Amounts or otherwise materially impede or delay the calculation of Revenue and Net Margin in accordance with Appendix B.

The plaintiff alleged that the highlighted language was an affirmative covenant obligating the buyer to consider the impact of any business decision on the earnout & avoid pursuing a particular course if it would be reasonably expected to have an adverse effect on the amount of the earnout. Although the Court held that plaintiff adequately pled violations of other provisions of the earnout agreement, it dismissed claims premised on the highlighted language.  This excerpt from a recent Morris James blog on the case explains the Court’s reasoning:

The Court found that the plain language of the relevant covenant created a negative covenant prohibiting positive action. In doing so, the Court declined to read the operative term “avoid” in a manner that would convert the negative covenant into an affirmative one.The Court’s reasoning turned on the plain meaning of the term “avoid” as well as the entirety of the relevant provision, which gave Mitchell the sole authority to direct the company’s strategy and business decisions.

Accordingly, the Court only sustained those parts of Quarum’s claim concerning prohibited actions by Mitchell (such as allegedly sabotaging development efforts or diverting customers), but dismissed those parts based on alleged business decisions and strategies that Mitchell did not pursue.

In reaching the conclusion that the language involved a negative covenant, the Court observed that a covenant obligating the buyer to avoid taking action “is, by definition, a negative covenant that [the buyer] could only breach by taking affirmative actions.” The Court also noted that if the covenant in question was interpreted as the plaintiff contended it should be, it would have effect of gutting the first clause of the provision and “would effectively place the power to manage the company in [the plaintiff’s] hands.”

John Jenkins