Chancery Finds That Buyers Breached Their Efforts Obligation—Auris and Alexion

In the Court of Chancery’s two most recent earnout decisions—Fortis v. Johnson & Johnson (“Auris”) (Sept. 4, 2024) and SRS v. Alexion (Sept. 5, 2024)—the court concluded that a buyer breached its contractual obligation to use “commercially reasonable efforts” to achieve an earnout.

In Auris, the parties had agreed to an “inward-facing” obligation, requiring that the buyer use efforts to develop the earnout product—a surgical robot—similar to the efforts it expended for its other “priority medical products.” The court held that the buyer breached this obligation when it caused the earnout product to compete head-to-head with, and then to combine with, one of the buyer’s competitive products. Those actions, the court found, were lesser than the efforts the buyer had made for the single comparator product and inconsistent with the priority status the buyer was required to accord to the earnout product.

In Alexion, the parties had agreed to an “outward-facing” obligation, requiring that the buyer use efforts to develop the earnout product—an antibody to treat disease—similar to the efforts of similar companies for similar products under similar circumstances. The court held that the buyer breached this obligation when it terminated the earnout product, purportedly due to concerns over new safety data and the resulting effect on the product’s order of entry to the market. The court, essentially rejecting the validity of the buyer’s purported business reasons for the termination, concluded that, under similar circumstances, another similar company would have gathered more safety data rather than terminating the product. The overlay to that conclusion was that the court viewed the buyer’s purported reasons for the termination as pretexts, with the real reason for the termination being that the buyer was acquired during the earnout period and its acquiror wanted the product terminated to help it secure the outsized merger synergies it had publicly promised.

Key Points

• While Auris and Alexion are consistent with the court’s new shift away from most often holding in favor of buyers in earnout cases, both of these cases were decided based on unusual facts and circumstances—and so do not, in our view, reflect any strong reinforcement of the new trend. In Auris, the court’s result was based on unusually strong seller-friendly earnout language in the parties’ merger agreement. In Alexion, the court’s result was based on the particular unusual factual context involving an idiosyncratic need of a company that acquired the buyer during the earnout period. Both cases underscore, once again, that the outcome in earnout cases is based on the specific facts and circumstances, including the specific language of the earnout provisions.
• Alexion highlights that the court will interpret a provision granting a buyer sole (or complete) discretion over an earnout product in context with the buyer’s efforts obligations. Based on the precise language used by the parties in their agreement, the court determined that, in making decisions about the earnout product, Alexion could consider only what actions other “typical biopharmaceutical companies” under similar circumstances would make—and could not consider its own “self-interest.” The court’s analysis, at a highly granular level, of the specific wording of the  provisions, as compared to the language in precedential cases, underscores that the precise language the parties use in their agreement is critical to the court’s result.
• Alexion also highlights that earnout parties utilizing an outward-facing efforts obligation should consider specifying whether the comparison is to actual actions taken by actual similar companies or, instead, to actions that would be expected to be taken by a hypothetical similar company. The Alexion parties did not so specify, and the court, determining that there were no exemplar companies for the first approach, applied the hypothetical approach—which led, effectively, to judicial second-guessing of the buyer’s business decisions for terminating the product, and a finding that a hypothetical similar company would not have terminated the earnout product under similar circumstances. Again, we note the overlay that, under the particular facts in this case, the court viewed Alexion’s purported business reasons as pretextual, with the real reason being an idiosyncratic need of the company that acquired Alexion.
• These decisions highlight that, when selecting between an inward- or outward-facing standard for the buyer’s efforts obligation, the parties should: consider whether there are in fact exemplar products under each standard; and, if so, which those products are; what the buyer’s efforts have been with respect to them; and whether those efforts comport with the parties’ expectations for treatment of the earnout product.
• These decisions highlight other practical issues that may arise when the buyer has products that are competitive with the earnout product and when a buyer with an earnout obligation is acquired during the earnout period. Auris underscores that, where the buyer has products that are competitive with the earnout product, the parties should consider addressing in their agreement how the competing products will be treated in relation to one another with respect to the earnout. In addition, in this context, the court may be more skeptical of the buyer’s motives for having acquired the product and any post-closing lack of efforts in support of it. Alexion underscores that, when a buyer is itself acquired during the earnout period, the buyer’s acquiror, as part of its due diligence, should consider the buyer’s efforts obligations with respect to any earnouts and whether they comport with the acquiror’s own plans and objectives.
• These decisions serve as another reminder that earnouts often lead to post-closing disputes. Accordingly, while earnouts make sense in pharma or biotech cases where almost all the value of the company depends on future developments and those developments are highly uncertain, earnouts are not necessarily a favored mechanism in other cases. Not only do disputes often arise relating to earnouts, but, as the outcome involves intensive judicial analysis of the factual context and the specific language of the parties’ agreement, it is often difficult for buyers to obtain dismissal of earnout claims at the pleading stage of litigation and often difficult to predict what the ultimate outcome of these cases will be. Where earnouts are used, thoughtful, clear, business-contextualized drafting of the earnout provisions is critical.

Earnout Efforts Standards

Under Delaware law, unless the parties provide otherwise, a buyer has no obligation to make efforts to achieve an earnout, but cannot act with the specific purpose of defeating the earnout. If the parties provide that a buyer must use reasonable or best efforts to support achievement of an earnout, the Delaware courts generally have defined that standard—if undefined by the parties—to mean that the buyer must take “all reasonable steps” to support achievement of the earnout.

Parties sometimes define an efforts obligation using an “inward-facing” standard—which requires the buyer to engage in a decision-making process, and to take actions to support achievement of an earnout, that are consistent with the buyer’s own (or the seller’s) process and actions in connection with its own similar products (or the seller’s past development of the product). Alternatively, parties may define an efforts obligation using an “outward-facing” standard, which requires the buyer to engage in a decision-making process, and take actions to support achievement of an earnout, that are consistent with the practices of similarly situated companies with respect to similar products under similar circumstances. In the case of an outward-facing standard, the comparison may be to actual similar companies and their actual actions taken “in the real world” with respect to similar products under similar circumstances (the so-called “yardstick approach”), or the comparison may be to a hypothetical similarly situated company and the actions it would be expected to take with respect to similar products under similar circumstances (the so-called “hypothetical company approach”).

The Auris Decision—The Buyer Breached an Inward-Facing Efforts Standard by Causing the Acquired Product to Compete, and then Combine, with Another Buyer Product

In Auris, in a post-trial decision, the court held Johnson & Johnson liable for more than $1 billion in damages to the former stockholders of Auris Health Inc. for breach of J&J’s obligations, set forth in the parties’ Merger Agreement, to use “commercially reasonable efforts” to achieve an earnout tied to further development of Auris’s market-leading surgical robot called “iPlatform.”

The Merger Agreement set forth an “inward-facing” definition of “commercially reasonable efforts,” based on J&J’s own “usual practices” for its “priority medical devices.” The Merger Agreement further required that J&J not intentionally act to defeat the earnout, and provided that it could not take into account the cost of any earnout payments when making its decisions.

The court found that J&J breached these obligations—“most blatantly” when, soon after closing, it directed that iPlatform compete head-to-head against J&J’s competing product, a surgical robot called Verb, and then directed that iPlatform combine with Verb, all of which resulted in significant disruption of iPlatform’s ability to achieve the earnout milestones, as J&J knew it would, according to the court.

Background. Auris, a venture-backed startup, had developed in record time two novel, market-leading surgical robots, “Monarch” (used to diagnose lung cancer) and “iPlatform” (used for laparoscopic and endoscopic procedures). At the same time, J&J was trying to develop a surgical robot, “Verb” (for orthopedic uses), but Verb’s progress was seriously stalling. J&J sought to acquire Auris “to solve its problems” with its robotics program. Auris, which was well-funded and had strong prospects, was wary of being acquired, especially by J&J because Verb was a potential competitor of iPlatform. J&J used an earnout to “put together a proposal [Auris] would not refuse.” It offered to pay $3.4 billion at closing and another $2.35 billion upon the achievement of certain commercial and regulatory milestones relating to the further development of Monarch and iPlatform. The regulatory milestones were ambitious, but Monarch and iPlatform were on track to meet them. Auris accepted the offer after heavy negotiation of the efforts standard in the merger agreement.

Soon after closing, J&J decided, with respect to iPlatform, that its budget could not support the development of iPlatform and Verb in parallel, so it would have to either “combine the robots or kill one.” J&J then “thrust iPlatform into a head-to-head faceoff against Verb,” to determine which was “the better bet.” Progress toward iPlatform’s regulatory milestones ceased while it had to focus on the series of procedures J&J required for the competition with Verb. J&J ultimately decided that iPlatform was the better bet; but then, to salvage its years-long investment in Verb, J&J directed that the Verb hardware and personnel be added to iPlatform. The combination created significant disruption for iPlatform, as it had to spend “countless hours creating engineering and software workarounds” to make the combination work. The combination also led to the departure of the entire legacy iPlatform team (a “devastating loss”).

iPlatform then did not meet the milestone events; and J&J did not pay the earnout. The Plaintiff brought suit on behalf of the former Auris stockholders. Vice Chancellor Lori W. Will held that J&J breached its contractual efforts obligations with respect to the earnout as it related to iPlatform (but not to Monarch).

Discussion

The inward-facing efforts obligation in the Merger Agreement was unusually seller-friendly. The Merger Agreement defined “commercially reasonable efforts” as “the expenditure of efforts and resources…consistent with the usual practice of J&J with respect to priority medical device products of similar commercial potential at a similar stage in product lifecycle to the applicable Robotics Products[.]” The court noted that the Merger Agreement provided Auris with “several layers” of protection:

• the inward-facing definition was “doubly advantageous” to Auris, as “[e]fforts to achieve the regulatory milestones [had to] be at the high level J&J—a top company in the industry—set for itself, and for ‘priority’ devices within J&J”;
• J&J’s efforts, expressly, were to be “in furtherance of achieving each of the Regulatory Milestones”—in other words, the court concluded, not in furtherance of J&J’s other corporate goals;
• J&J was specifically prohibited not only from acting “with the intention of avoiding” payment of the earnout, but also from making decisions “based on taking into account the cost of making any Earnout Payment(s)”—which, the court stated, was “more restrictive” language than the typical requirement that a buyer not act “for the purpose of thwarting” an earnout; and
• the Merger Agreement did not include the typical provision stating that the buyer would have “complete discretion” over decisions relating to the acquired company’s business.

The court held that causing iPlatform to compete and then combine with Verb violated J&J’s efforts obligation. The court found that the head-to-head competition exercise with Verb caused delays in working toward the regulatory milestones; and that the combination with Verb (which effectively rendered iPlatform “a parts shop for Verb”) caused further complications and disruptions for the development of iPlatform. Further, according to the court, J&J knew that the competition and combination with Verb would “hinder, rather than promote, the earnout.” Moreover, the court concluded, “J&J viewed the resulting delays as beneficial since it could avoid making the earnout payment.” The court wrote: “When J&J’s actions put the first iPlatform milestone out of reach, the other milestones fell like dominos.” And, the court noted, J&J’s actions that impaired iPlatform’s development and ability to achieve regulatory milestones “benefitted another [J&J] device—Verb—at iPlatform’s expense.” Causing iPlatform to compete and combine with Verb was inconsistent with the “priority” treatment the efforts standard required. Thus, causing iPlatorm to compete and combine with Verb, standing alone, was “sufficient to find that J&J breached its efforts obligation,” The court wrote: “[A] ‘priority’ device would not have to endure a costly battle merely to remain operative,” nor would it have to “have its system, technology, and team diluted to fix another device’s problems.”

The court found, in addition, that J&J’s treatment of iPlatform was “starkly different” from its treatment of the comparator product. J&J identified only a single similar J&J product that was at the same stage of development—a surgical robot (for orthopedic procedures) called Velys. Velys had been “developed through an MVP strategy starting with simple, buildable functionality and a single indication. It lacked perfect performance statistics before receiving its first FDA clearance in January 2021 and was not superior (or even equivalent) to its market-leading rival upon launch in August 2021. Velys employees were given cash incentives to achieve rapid FDA clearance.” J&J’s treatment, by contrast, involved: (i) pursuing a more complex regulatory strategy than the MVP strategy (even though the MVP strategy was typically used for priority medical products; the milestones framework in the Merger Agreement appeared to have contemplated use of the MVP strategy; and iPlatform would have been more likely to be able to satisfy the MVP strategy requirements) (ii) a write-down on the books of the value of the milestones, then an announcement that the milestones were “canceled,” and then a revision of the targets for iPlatform employee’s bonuses to make them different from the milestones in the Merger Agreement—all of which “negatively affected employees’ motivation to work towards the iPlatform…regulatory milestones”; (iii) changes to iPlatform’s reporting structure, with the operational team to report to a person who had no experience with robotic surgical products; and (iv) after the combination of iPlatform and Verb, significant investment by J&J into the Verb program.

The court rejected J&J’s argument that it had discretion under the Merger Agreement to make a “commercially reasonable business decision” to combine iPlatform with Verb in furtherance of its overall robotics program.  The court noted that the Merger Agreement did not contain language granting J&J sole discretion over development of iPlatform. Further, the court held that the ten factors listed in the Merger Agreement that J&J could take into account when fulfilling its efforts obligation—such as safety, risks inherent in development and commercialization, likelihood and difficulty of obtaining regulatory approval, and expected profitability—did not give J&J broad discretion with respect to the development of iPlatform. Rather, the court stated, under the Merger Agreement: “J&J could consider [these] various factors in assessing the level of efforts to devote. But the end goal of those efforts was to achieve the iPlatform regulatory milestones—not to further J&J’s robotics program.”

The court rejected J&J’s argument that its efforts devoted to iPlatform were commercially reasonable because iPlatform’s funding vastly exceeded that of Velys (or any other medical device program at J&J). J&J invested “over $2.25 billion in the Auris program” over about three years, and purchased a $20 million company to buttress Auris’s capabilities. The court viewed it as “an oversimplification to view these funds as furthering the achievement of the iPlatform regulatory milestones.” A large proportion of the funds appeared to have been devoted to J&J’s robotics program generally, for litigation expenses, and for other items not necessarily related to “furthering the achievement of the iPlatform regulatory milestones.”

Other rulings of note. (i) Implied covenant of good faith. The court held that J&J also breached the implied covenant of good faith and fair dealing—on the basis that, when the FDA informed J&J that it would have to pursue a different regulatory pathway for iPlatform than the one that was then being pursued, J&J failed to devote efforts to achieve the revised regulatory pathway. (ii) Fraud. The court held that J&J committed fraud with respect to one of the milestones related to its Monarch robot. The milestone was tied to regulatory clearance by a near-term deadline using a J&J-developed catheter. J&J allegedly had told Auris that this milestone was so certain to be met that J&J viewed the associated milestone payment as upfront consideration, but had not told Auris that J&J was under a regulatory investigation because a patient in a clinical study using the catheter had recently died, which put the milestone in doubt.

Calculation of damages. The Plaintiff sought $2.35 billion in damages, which was the amount of earnout payments not made. The court instead weighted each milestone payment by the parties’ estimated probability of its achievement at the time of the merger, utilizing the Plaintiff’s expert’s averaging of the parties’ respective estimates on the probability of achievement. Notably, the court commented that, as a result of the buyer’s actions, while Auris’s former stockholders could be compensated with a damages award, “what remains irretrievably lost is the transformative potential of Auris’s robots.”

The Alexion Decision—The Buyer Breached an Outward-Facing Efforts Standard by Terminating the Earnout Product

In Alexion, in a post-trial decision, the court held that Alexion Pharmaceuticals breached its obligation in its Merger Agreement with Syntimmune, Inc. to use commercially reasonable efforts to support achievement of earnout milestones tied to further development of the monoclonal antibody known as ALXN1830 (the “Antibody”) for certain illnesses (or “indications”).

The Merger Agreement called for an upfront purchase price of $400 million, and an earnout of up to $800 million, payable in installments upon the completion of each of eight milestones. The Merger Agreement defined “Commercially Reasonable Efforts” using an “outward-facing” standard—with the efforts to be measured by what a similarly situated company would do under similar circumstances. The court determined that the outward-facing standard required comparison to the efforts that a hypothetical similar company would have made under similar circumstances; and concluded that such a company would not have terminated the Antibody program.

Background. When Alexion acquired Syntimmune, at least four competitors were developing therapies similar to the Antibody. Alexion believed it could distinguish the Antibody, however, including by being the first to develop a subcutaneous (rather than intravenous) means of administration. The Antibody program encountered problems, however, including contamination of its drug supply and the need to pause ongoing trials due to the COVID-19 pandemic. In April 2020, Alexion publicly announced a new project to demonstrate value to investors—called “10 by 2023,” the goal was to launch ten products by 2023. Alexion reallocated a significant portion of the Antibody program’s funds to other programs. The Antibody program’s funding was not completely removed, but its deprioritization (the “2020 Deprioritization”)  meant that, a few months later, when Alexion was willing and able resume its Antibody studies (after resolution of the contamination- and pandemic-related problems), it could not do so. Alexion thereafter continued to develop the Antibody, but its development fell behind its competitors’ programs.

In July 2021, AstraZeneca acquired Alexion. In connection with the acquisition, AstraZeneca publicly announced that it expected about $500M in recurring merger synergies. Soon after the acquisition, AstraZeneca launched a review of all of Alexion’s programs, including the Antibody program. Also at this time, new (but inconclusive) data from an ongoing Phase 1 trial of the Antibody suggested the possibility of certain safety risks. In December 2021, Alexion terminated the Antibody program, citing the potential safety concerns and the resulting expected later entry into the market.

The Plaintiff brought suit on behalf of the former securityholders of Syntimmune, alleging that Alexion failed to use Commercially Reasonable Efforts, as defined in the Merger Agreement, to achieve the earnout milestones. Vice Chancellor Morgan T. Zurn held that Alexion breached its efforts obligation (as well its obligation to make the first milestone payment—$130 million—which, the court concluded, under the terms of the Merger Agreement, had been earned). The court stated that it will determine damages for the contractual breach with respect to the remaining seven earnout payments in a subsequent decision.

Discussion

Alexion’s outward-facing efforts obligations. The Merger Agreement defined “Commercially Reasonable Efforts” as:

such efforts and resources typically used by biopharmaceutical companies similar in size and scope to [Alexion] for the development and commercialization of similar products at similar development stages taking into account, as applicable, [the Antibody’s] advantages and disadvantages, efficacy, safety, regulatory authority-approved labeling and pricing, the competitiveness in the marketplace, the status as an orphan product, the patent coverage and proprietary position of [the Antibody], the likelihood of development success or Regulatory Approval, the regulatory structure involved, the anticipated profitability of [the Antibody], and other relevant scientific technical and commercial factors typically considered by biopharmaceutical companies similar in size and scope to [Alexion] in connection with such similar products.

The Merger Agreement also provided that: Alexion had “sole discretion” over the development of the Antibody, but subject to its obligation to use Commercially Reasonable Efforts to develop the Antibody; Alexion had “no obligation…to achieve any [milestone] events…that would give rise to an Earn-Out Payment”; Alexion was not required “to act in a manner which would otherwise be contrary to prudent business judgment”; and “the fact that [a milestone] objective is not actually accomplished is not dispositive evidence that [Alexion] did not in fact utilize its Commercially Reasonable Efforts in attempting to accomplish the objective.”

The court applied a “hypothetical company approach” to the outward-facing efforts standard. The court acknowledged that the reference in the efforts standard to “biopharmaceutical companies” could refer to “actual existing companies and the efforts and resources they actually used in developing similar products at similar stages.” But, the court wrote, “the reference to the efforts and resources the companies ‘typically used,’ and the ‘scientific, technical and commercial factors’ they ‘typically considered,’ call[ed] for a more abstract and aggregated industry standard.” Further, the court stated, the yardstick approach was “unworkable” in this case because there were “no adequate exemplar companies, as none of Alexion’s competitors operated under the same conditions as Alexion [nor even as one another].” Therefore, the court stated, “[t]he realities of applying the provision call[ed] for a hypothetical company approach.” (The court recently reached that same result, for the same reason relating to inherent variation among drug development companies, in Himawan v. Cephalon (Apr. 30, 2024)—discussed briefly below.)

The court analyzed the interrelationship of the provisions in the parties’ agreement granting sole discretion to Alexion with respect to the earnout product, but subject to Alexion using reasonable efforts to develop the product. In its recent Himawan decision, the court held that a buyer’s sole discretion provision and outward-facing efforts obligation were best interpreted together as meaning that the buyer was obligated to develop the product if doing so was in the buyer’s self-interest. In other words, the buyer could not make an uneconomic decision to terminate the product, but could terminate the product if doing so was commercially reasonable. In Alexion, the court held that Alexion’s right to sole discretion with respect to development of the Antibody program and its outward-looking efforts obligation together meant that Alexion could not terminate the program based on its own self-interest, but only based on what other similar companies would do in their self-interest under similar circumstances. The court found the efforts standard in Alexion to be “more outward-facing” than the standard in Himawan. The difference, the court stated, is that, the standard in Himawan, although outward-facing, expressly permitted the buyer “to consider its own efforts and cost required for the undertaking,” the standard in Alexion did not permit Alexion to consider its own self-interest, only the self-interest of other similar companies. “Alexion’s efforts obligation is pegged to typical factors considered by typical companies—not Alexion’s own self-interest.” Alexion was permitted to “consider anticipated profitability,” for example, the court stated, “only insofar as typical companies might typically consider it.” Rather than considering its self-interest in determining what is commercially reasonable, Alexion can consider its self-interest only in drawing the upper bound of its commercially reasonable efforts” (because “Alexion’s obligation does not require that it act in a manner which would otherwise be contrary to prudent business judgment”). The court’s analysis on this important point that was pivotal to the outcome of the case underscores the critical difference that the specific language of the parties’ agreement, at a very granular level, can make with respect to the court’s interpretation of earnout provisions, including the efforts obligation.

The court concluded that a hypothetical similar company under similar circumstances would not have terminated the Antibody program—and that the program really was terminated due to AstraZeneca’s idiosyncratic objectives. The court reviewed “holistically” the factors that Alexion asserted were the basis for the termination, and essentially rejected the validity of Alexion’s purported business reasons for the termination (especially noteworthy given that the Merger Agreement granted Alexion sole discretion over development of the Antibody). With respect to Alexion’s purported new safety concerns, the court determined that the record evidence showed that the new safety data was inconclusive. Under similar circumstances, the court stated, “[a] hypothetical company using commercially reasonable efforts would respond by gathering further data…—not by terminating the program.” With respect to Alexion’s purported concerns about the order of entry to market, the court acknowledged that, at the time of the termination, the Antibody was expected to be “fifth overall”; but, the court stressed, Alexion still expected to be first to market for two new indications it was pursuing. With respect to Alexion’s consideration of “other advantages and disadvantages” of the Antibody, the court noted the Antibody’s advantages in having “strong patent protection until 2036, after its competitors’ would have expired”; and in not having the effect of lowering albumin (which would make it appealing to older people and people with kidney problems). Perhaps most importantly, the court also noted that, at the time of the termination, Alexion itself appeared to be still optimistic about the Antibody program and to want to continue it. The court observed that its analysis led to the question why then Alexion terminated the program. The answer, the court stated, was that the “the decision was influenced, motivated by, or driven by AstraZeneca’s pursuit of merger synergies.”

The court found that Alexion’s 2020 Deprioritization of the Antibody program, in this case, did not itself constitute a breach of the efforts obligation. Alexion terminated the Antibody program “because [the Antibody] could not be launched quickly enough to be part of [the 10 by 2023 Goal].” That was “an idiosyncratic corporate initiative” that “[could] not satisfy an outward-facing efforts clause based on the typical efforts of similar companies,” the court stated—and, indeed, at that time, Alexion’s competitors all were moving forward with, and not deprioritizing, development of their products that competed with the Antibody. Nonetheless, however, the court ruled that the Plaintiff could not obtain a judgment based on the 2020 Deprioritization because it had offered no evidence to establish the extent, if any, to which the delays in development that resulted from the 2020 Deprioritization contributed to Alexion’s failure to achieve the milestones (as opposed to other causes known to have caused delay, such as the pandemic).

Practice Points Arising from Auris and Alexion

• Parties should be aware that there is a broad spectrum of earnout provisions.  Where the parties end up on the spectrum, in terms of protection for the seller as compared to flexibility for the buyer, in most cases will depend on the parties’ respective negotiating leverage. In addition, a buyer’s history with earnouts may impact the parties’ negotiations. Before a seller enters into an earnout, the seller should check the buyer’s history with respect to earnouts. Buyers should be mindful of potential reputational damage, in terms of their ability, in the future, to enter into earnout arrangements and/or obtain desired earnout terms, if they have a problematic history with respect to compliance with their earnout obligations.
• The court generally will interpret earnout provisions precisely as written. Earnout provisions should be drafted as bespoke provisions, tailored to the specific product, business, company, industry, and situation at hand, in a process involving lawyers and the business people who understand the specific product or business best. Careful, specific, business-contextualized consideration of potential issues that may arise relating to the earnout is critical. Also it , should be made clear how the earnout provisions relate to other provisions of the merger agreement (such as the buyer’s level of discretion to run the acquired business post-closing).
• A buyer should be aware that a provision granting it “sole discretion” to develop the earnout product will generally be viewed as subject to the buyer’s specified efforts obligation. The parties may wish to make clear in the agreement how they intend the discretion provision and the efforts standard to interrelate.
• A seller may want the agreement to expressly state that: (i) the buyer’s efforts obligation relates to furthering achievement of the milestones for the earnout product, and not to furthering the buyer’s other corporate goals; and (ii) the buyer cannot make decisions on a basis that takes into account the cost of making earnout payments. A buyer may want the contrary language. Also, the parties may wish also to specify, with respect to any list of factors the buyer can take into account in connection with an outward-looking efforts obligation, whether and how the buyer can consider its own “self-interest.” For clarity, the parties may wish to specify in the agreement how they intend the efforts standard provided to be interpreted, including examples of hypothetical situations and how the standard would work in those specific circumstances.
• Parties should consider providing in their agreement any specific actions the buyer (or seller) will be required to make, will not be required to make, or will be prohibited from making, in connection with developing the earnout product. If, for example, the parties have discussed particular actions that they anticipate will have to be taken (or not taken) to ensure or maximize earnout payments, the parties should set them forth in express covenants in the agreement. If there are other specific actions the seller believes the buyer should take in furtherance of the earnout, or other specific flexibility the buyer wants to preserve—particularly with respect to issues that are the most critical to achievement of the earnout or the most likely to be subject to manipulation or dispute—the parties should consider setting them forth in express covenants in their agreement.
• In selecting between an inward- or outward-facing efforts standard, the parties should consider which comparators would be applicable under each standard—and then consider which standard provides the comparators that comport best with how the buyer intends to proceed or the seller expects the buyer to proceed, as the case may be. If an outward-looking standard is selected, the parties should specify whether the comparison is to be made using a yardstick approach or hypothetical company approach. (Notably, in Alexion and Himawan, the Court of Chancery has stated that there may be no outward-facing comparators for a company developing pharmaceuticals, given inherently unique circumstances at every drug development process company.) If an inward-facing standard is selected, the parties may wish to identify by name particular products that will be used as the comparators—rather than characterizing the comparators (for example, in Auris, “priority products”), which could lead to disputes as to which products meet that characterization.
• An inward-facing standard may offer a buyer a greater degree of flexibility than an outward-facing standard.  First, under an inward-facing standard, depending on the facts and circumstances, a buyer may be able to adjust its efforts for its other products if beneficial for its efforts obligations with respect to the earnout product. Also, particularly where there is a long earnout period, an inward-facing standard may better accommodate unique corporate needs or objectives that may develop over time (i.e., needs that would not necessarily apply to other companies).
• Before taking actions with respect to, or that may affect, an earnout product, a buyer should review the agreement to determine whether the action is permitted under the efforts standard. Determining whether such actions would violate the efforts standard will require close analysis of the specific language of the earnout provisions and their interrelationship with other merger agreement provisions. As highlighted in Auris, such actions might include, for example: causing the acquired product or business to compete head-on, or to compete, with any of the buyer’s existing products; failing to identify and pursue alternative regulatory strategies when others are foreclosed; revising the incentive program for, or making comments that may negatively affect the motivation of, the employees working on the acquired product; changing the reporting structure for the employees working on the acquired product or business (such as by having them report to a person without experience with the specific type of product or business); significantly decreasing the funding or other corporate support for the earnout product; and significantly increasing the investment in other businesses (perhaps, even if significant funding is still being provided for the acquired product or business). As highlighted in Alexion, such actions might include deprioritizing or terminating the acquired product or business.
• A buyer should monitor compliance with the efforts standard on an ongoing basis during the earnout period. If an inward-facing standard applies, the buyer should monitor the efforts it is making with respect to its own products or businesses that are the comparators, and benchmark its earnout efforts against those efforts. If an outward-facing standard applies, the buyer should monitor the efforts its peers (or other companies that are the comparators) are making, and benchmark its efforts against those efforts.
• Special issues may arise where the buyer has competing or potentially competing products. The parties should consider how the competing products will be treated in relation to one another with respect to the earnout—and should consider providing explicitly in their agreement how the products will compete and whether they can be combined. Before causing products to compete or combine, a buyer should carefully consider the potential impact on the earnout and whether the action would violate the agreement. In addition to issues relating to competition and/or combination (the issues in Auris), the parties should consider addressing explicitly the issue (not present in Auris) as to the allocation of revenues from the various products or businesses for purposes of any formula relating to calculation of the earnout payments.
• A post-closing acquisition of a buyer subject to an earnout obligation may create certain complications. Alexion highlights that, if the buyer is acquired, and thereafter the earnout product or business is terminated, the court may be skeptical that the termination was consistent with the earnout-buyer’s efforts obligations, rather than having been due to the acquiror’s self-interest (such as achieving merger synergies). In addition, an acquiror of a company with earnout obligations should consider whether the target’s earnout obligations, which generally will continue to be binding on the earnout-buyer, are consistent with the acquiror’s synergy goals and post-closing plans. A seller may wish to consider specifying certain consequences to the earnout in the event of certain acquisitions of the earnout-buyer, such as acceleration of the earnout.
• Sellers should be careful when commenting on the likelihood of achievement of milestones. Overstating the likelihood of achievement, particularly where the seller has negative information not shared with the buyer, can lead to fraud charges (as occurred in Auris).
• Parties should be aware that the court may use the parties’ negotiating process and internal communications to interpret ambiguous earnout provisions.  In Alexion, for example, in determining that the criteria for the first milestone had been satisfied, the court reviewed the full history of the parties’ negotiations, as well as internal emails, to determine Alexion’s own contemporaneous interpretation of the agreement language. It cannot be emphasized enough that individuals should craft carefully their planning documents and internal communications, including emails, keeping in mind that they may be subject to discovery in the event of litigation. Humor, sarcasm, playing devil’s advocate (without stating as much), and ambiguous statements should be avoided, as they could later be misinterpreted.

Other Recent Earnout Decisions

We note the following additional earnout decisions issued recently:

Himawan—Earnout Claims Against a Buyer are Dismissed Based on Outward-Facing Efforts Standard.  In Himawan v. Cephalon (Apr. 30, 2024), the Court of Chancery, in a post-trial decision, held that Cephalon, after buying Ception Therapeutics, did not breach its obligation to use “Commercially Reasonable Efforts” to develop Ception’s single pharmaceutical product, “RSZ,” for use in the treatment of a specific disease called EoE. The Merger Agreement provided for an earnout payment to be made if RSZ received regulatory approval to treat EoE. Cephalon abandoned its attempts to commercialize RSZ for EoE after testing results for its treatment of a different disease showed more promise. The earnout provisions stated that (i) Cephalon had “complete discretion” with respect to the development of RSZ; and (ii) Cephalon’s discretion was subject to an obligation to use Commercially Reasonable Efforts to achieve the milestone targets. “Commercially Reasonable Efforts” was defined as “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.” The court interpreted the efforts definition to set an objective standard based on “similarly-situated pharmaceutical companies and their actions in the real world” in developing different drugs for EoE. The court determined, however, that this method was unworkable, as “no exemplar companies operate under the actual conditions of [Cephalon].” Rather, the circumstances of companies developing drugs, even if for the same condition, are inherently varied, the court stated. The court held that the best interpretation of the contract was that, “if a reasonable actor [when] faced with the same restraints and risks [with respect to developing RSZ] would go forward in its own self-interest, [Cephalon was] contractually obligated to do the same.” The court found that Cephalon’s actions were commercially reasonable, as the record at trial established that RSZ was not likely to receive regulatory approval for EoE. See here our Briefing that discusses the decision in depth.

Beckett—Earnout Claims Against a Buyer Survive Based on Ambiguity in Provisions Relating to Acceleration of Payment and Good Faith Negotiations. In Medal v. Beckett (Aug. 22, 2024), the Court of Chancery, at the pleading stage of litigation, declined to dismiss claims that Beckett Collectibles, by failing to make certain earnout payments, breached the Stock Purchase Agreement pursuant to which it had acquired Due Dilly Trilly (“DDT”). While the decision focused on a number of procedural issues, the court’s brief discussion of the substantive earnout claims provides guidance for avoiding ambiguity in provisions relating to (i) the acceleration of earnout payments under specified circumstances and (ii) a requirement that the parties negotiate in good faith to resolve earnout disputes before bringing litigation. The decision highlights that: (i) language providing for payment of “unpaid” earnout amounts under specified circumstances should be clear as to whether the provision calls for acceleration of all of the unpaid earnout payments or just for payment of earnout payments earned but not yet paid; and (ii) language requiring the parties to negotiate or cooperate in good faith to seek to resolve any disputes before bringing litigation may not be enforceable if there is insufficient detail as to how the parties can fulfill the obligation and/or there are indications that the negotiations would be futile. See here our Briefing that discusses the decision in depth.

Philips—Earnout Claims Against a Buyer Survive Based on Ambiguous Milestone Relating to FDA Approval. In WT Representative v. Philips (Aug. 16, 2024), the Court of Chancery, at the pleading stage, declined to dismiss claims that Philips Holdings USA, which had acquired Vesper Medical, breached the parties’ merger agreement when it failed to make a post-closing earnout. The earnout was contingent on Philips’ obtaining FDA approval of Vesper’s “DUO Venous Stent Systems.” While Philips had sole discretion with respect to the FDA approval, it was subject to an “outward-facing” efforts standard and an express obligation not to act in bad faith. Although the earnout provisions included detailed definitions, the court found they were ambiguous as to whether the FDA approval that was obtained—which covered all of the numerous sizes of stents included in the definition of the Systems but one (the narrowest size, which Vesper had ceased to use before the deal with Philips)—was sufficient to trigger the earnout payment. The decision highlights that “outward-facing” post-closing efforts standards relating to achieving the earnout can present difficult practical issues. See here our Briefing that discusses the decision in depth.

Medtronic—Earnout Claims Against a Buyer are Dismissed Based on Language Prohibiting Only Buyer Actions with the “Primary Purpose” of Defeating the Earnout. In Fortis v. Medtronic Minimed (July 29, 2024), the Court of Chancery, at the pleading stage, dismissed claims against Medtronic for, allegedly, having purposefully defeated a $100 million earnout payment. The merger agreement required that, post-closing, Medtronic not take action with the primary purpose of defeating the earnout. Delaware law generally requires only that a buyer not take action with the specific purpose of defeating an earnout, unless the parties’ agreement provides otherwise. The court held that the merger agreement standard in this case imposed an even narrower obligation than under the Delaware law standard—with Medtronic permitted to take actions motivated by defeating the earnout so long as some other purpose was “more central” to Medtronic’s decision. The decision thus highlights the need for particular care in drafting a buyer’s post-closing obligations with respect to an earnout. In this case, use of the word “primary” rendered the merger agreement standard significantly narrower than the Delaware law standard. We note that the case was unusual in that the merger agreement set forth what the court called an “exceptionally buyer-friendly standard” for the buyer’s post-closing obligations with respect to the earnout; and in that, notwithstanding that the standard depended on the buyer’s “primary purpose” for its actions, in the court’s view the plaintiff did not plead allegations relating to Medtronic’s purpose in taking the actions that led to the earnout milestone not being met. See here our Briefing that discusses the decision in depth.