DealLawyers.com Blog

December 20, 2021

Earnouts: Del. Chancery Refuses to Dismiss Fraud & Implied Covenant Claims

The Delaware Chancery Court hears a lot of earnout cases, but very few have financial stakes as large as those involved in Vice Chancellor Will’s recent decision in Fortis Advisors v. Johnson & Johnson, (Del. Ch.; 12/21).  The litigation arose out of the 2019 acquisition of medical device manufacturer Auris Health by J&J’s Ethicon subsidiary. The deal’s consideration included an upfront payment of $3.4 billion with post-closing earnout payments of up to $2.35 billion, subject to the achievement of predetermined regulatory & sales milestones.

After a series of events including a shift in FDA policy that put Auris’s robotically assisted surgical device (RASD) product on a longer regulatory approval timeline, J&J signaled that it didn’t believe the earnout was payable by announcing that it had released its reserves for the earnout payment. That action prompted the plaintiff filed to file its lawsuit. The plaintiff threw the kitchen sink at the defendants in terms of claims, and the defendants filed a motion to dismiss. The Vice Chancellor dismissed some of them, but she found that the plaintiff had sufficiently pled, among other claims, common law fraud & breach of the implied covenant of good faith and fair dealing. 

The plaintiff based its fraud claim on allegations that J&J and Ethicon committed fraud by making false extra-contractual representations and withholding material facts during the negotiation process. The defendants responded by pointing to the merger agreement’s exclusive remedy provision, which said that the indemnification provisions were the exclusive remedy for any action associated with the transactions contemplated by the agreement. The only fraud claims that the merger agreement carved out of the exclusive remedy provision were those relating to “making the representations and warranties in this Agreement.” Since that carveout didn’t extend to extra-contractual fraud claims, they were effectively barred.

Relying heavy on the Abry Partners decision, Vice Chancellor Will rejected the defendants’ arguments. She held that the language of the exclusive remedy provision was not equivalent to the clear non-reliance language required by Abry Partners:

Unlike the parties in Abry Partners, Auris did not disclaim reliance on extra-contractual statements anywhere in the Merger Agreement. Indeed, the fact that Ethicon expressly disclaimed reliance but Auris did not suggests that Auris was permitted to rely on the defendants’ assurances. The exclusive remedy provision therefore cannot, by itself, eliminate Fortis’s fraud claims.

To find otherwise would ignore the delicate balance that Delaware courts have struck between supporting freedom of contract and condemning fraud. If the defendants intentionally misrepresented a fact that induced Auris to enter into the Merger Agreement, and Auris did not explicitly disclaim reliance on extra-contractual representations, it cannot be barred from recovering for that purported fraud.

Vice Chancellor Will also refused to dismiss the plaintiff’s implied covenant claims, which were premised on Ethicon and J&J’s covenant to use commercially reasonable efforts to obtain FDA approval of its RASD product under the agency’s then existing policy.  The plaintiff contended that since neither party contemplated the possibility of a change in that policy, the implied covenant of good faith and fair dealing should apply. The Vice Chancellor agreed:

The implied covenant comes into play in precisely this scenario, where “the parties simply failed to foresee the need for the term and, therefore, never considered to include it.” Fortis alleges that the FDA had routinely cleared RASDs through the 510(k) pathway for decades and that the parties to the Merger Agreement believed the FDA would clear iPlatform through the 510(k) pathway.

Fortis also asserts that the FDA indicated to Auris in late 2018 that the 510(k) pathway would be appropriate for iPlatform. The implied covenant is well situated to address such “unanticipated developments” as a means to assess what the parties would have agreed to had they known about the FDA’s policy change when they executed the Merger Agreement.

This blog is already pretty lengthy, so in closing I’ll just point out that the Vice Chancellor also upheld several other interesting claims asserted by the plaintiff, including recission based on mutual mistake, unjust enrichment, and specific performance. The discussion of those claims begins on p. 41 of her opinion, and I’m sure will be touched on by law firm memos in the coming weeks.

John Jenkins