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Delaware Court of Chancery Decision Provides Guidance on M&A Earnouts

In Shareholder Representative Services LLC v. Albertsons Companies, Inc., 2021 WL 2311455 (Del. Ch. June 7, 2021), the Delaware Court of Chancery (Slights, V.C.) provided key guidance on mergers and acquisitions (“M&A”) earnout disputes regarding contractual earnout language, the applicability of the implied covenant of good faith and fair dealing, extra-contractual discussions and promises and post-closing behavior of the acquirer.  This opinion serves as a reminder to M&A transaction parties on important drafting concepts in earnouts, as well as how to conduct themselves during the negotiations and earnout period.

DineInFresh, Inc., d/b/a Plated (“Plated”) was an e-commerce subscription meal kit delivery company whose business model involved consumers subscribing to its services in exchange ingredients and recipes for home-cooked meals delivered directly to their homes.  In September 2017, Plated and Albertsons Companies, Inc. (“Albertsons”) entered into an Agreement and Plan of Merger, which provided for an upfront cash payment by Albertsons to Plated’s stockholders of $175 million.  Plated would operate as standalone business, and the stockholders had an earnout opportunity of up to $125 million payable over the next three years based on achieving certain financial milestones.  Additionally, the merger agreement contained the following post-closing “management language”:

Except as otherwise set forth in this clause (vii), [Albertsons] will have the exclusive right to make all business and operational decisions regarding [Albertsons] and its Subsidiaries (including [Plated]) in its sole and absolute discretion without regard to any other interest and will have no obligation to operate [Plated] in a manner to maximize achievement of the Earnout Issuance; provided, however, that [Albertsons] will not, and will cause its Affiliates not to, take any action (or omit to take any actions) with the intent of decreasing or avoiding any Earnout Issuance.

Plated missed the earnout milestones, and Albertsons did not make the earnout payment to Plated’s former stockholders.

Plaintiff Shareholder Representative Services LLC, on behalf of Plated’s former stockholders, thereafter filed suit in the Delaware Court of Chancery, alleging that Plated would have succeeded and at least a portion of the earnout would have been paid but for Albertson’s active interference with Plated’s business.  Plaintiff asserted three causes of action: (1) breach of contract by acting with the intent of avoiding the earnout; (2) breach of the implied covenant of good faith and fair dealing; and (3) fraudulent inducement.  According to Plaintiff, Albertsons had a negative take on e-commerce, and accordingly took actions that undermined the business.  It reallocated Plated’s resources to get Plated’s product into the brick-and-mortar stores, altered public messaging to focus on retail instead of e-commerce, promises of decreased transportation costs were empty and misguided, Plated was not provided broad latitude in running its business independently and badly mismanaged Plated.  Albertsons moved to dismiss.

The Court granted the motion in part.  Notably, it declined to dismiss Plaintiff’s breach of contract cause of action based upon the negotiated management carveout in the merger agreement.  Referencing Windy City Invs. Hldgs., LLC v. Teachers Ins. & Annuity Ass’n of Am., 2019 WL 2339932 (Del. Ch. May 31, 2019), the Court held the “intent of decreasing or avoiding any Earnout Issuance” carveout would be breached if buyer/acquirer’s actions post-closing were, at least in part, done with the purpose and intent of reducing the earnout.  The Court concluded that, as pleaded, it was reasonably conceivable Albertsons’ post-closing business initiatives were formulated at least in part, with the purpose and intent of reducing the earnout.  As the Court explained, “the Complaint well-pleads that Albertsons told Plated it would follow Plated’s e-commerce business plan when it had no intention of doing so, knew that business plan was the only way to achieve the Earnout and then deliberately ignored the plan from the outset knowing that decision would cause Plated to miss the Earnout milestones.”

The Court, though, dismissed plaintiff’s claim that Albertsons breached the covenant of good faith and fair dealing.  “[W]here the parties themselves bargain for limits on the buyer’s discretion, as here, there is no gap for the implied covenant to fill.”  According to the court, the earnout clearly gave the operation of the business, post-closing, under the exclusive control of Albertsons and Albertsons alone.  If Plaintiff wanted such exclusive control and absolute discretion to be conditioned on good faith, Plaintiff should have bargained as such.  Instead, “Plated bargained for a provision that prevented Albertsons from intentionally scuttling the Earnout. That was the bargained-for means by which Plated managed the risk of non-payment.”  Plaintiff also argued that Plated’s “‘reasonable expectations were frustrated’ by Albertsons, and that the implied covenant must operate as the vehicle by which those frustrated expectations can be realized.”  To this, the Court stated that Plated’s expectation that the earnout would be realized was unreasonable as “[t]hat view of contingent consideration ignores the risk allocation that animates an earnout; parties anticipate (or should anticipate) at the time of contracting that earnouts might be paid or they might not be paid.”

Finally, Plaintiff asserted that Plated’s former stockholders were fraudulently induced into entering into the merger agreement in the executed form because they relied upon “a constellation of alleged oral misrepresentations made during negotiations, including that Albertsons promised to give Plated the tools and resources to further scale their operations, provide equity to retain key employees, give the Plated management team broad latitude in setting compensation, and prioritize Plate’s e-commerce subscription business over in-store meal kits.”  Plaintiff also alleged that “Albertsons concealed its true motive to prioritize Plated’s role in Albertsons’ existing brick-and-mortar business at the expense of e-commerce.”  In dismissing this cause of action, the Court held that it is well settled in Delaware that “[t]he presence of a standard integration clause alone, which does not contain explicit anti-reliance representations and which is not accompanied by other contractual provisions demonstrating with clarity that the plaintiff had agreed that it was not relying on facts outside of the contract, will not suffice to bar fraud claims.”  Although the merger agreement’s integration clause did not have such anti-reliance language, the Court nevertheless dismissed the cause of action because the alleged misrepresentations were future promises and future intent with respect to post-closing business operations, and thus Plated was not justified in relying on such misrepresentations.  As the Court explained, if “Plated wanted contractual commitments from Albertsons that it would operate Plated in a particular manner post-closing, Plated could and should have bargained for those commitments as carve-outs.”

Earnouts often end in dispute.  Accordingly, if you are contemplating an earnout in connection with your M&A transaction, consider the following:

  1. Implied Covenant gap-filling is not applicable when post-closing conduct of the parties is negotiated and clear. If total control of the target company is ceded to the buyer in the contract, only qualified by the limitation that the acquirer may not act with the intent of avoiding the earnout payment, there is no implied good-faith read into such contractual provision.

  2. If the parties negotiate that the acquirer may not act with the intent of avoiding the earnout payment, be aware that “intent” does not just mean sole or primary intent. Acquirer must exercise caution that any actions they take post-closing can be construed as animated by a partial or secondary “intent” of avoiding the earnout.

  3. Acquirers should include “anti-reliance” language in the integration clauses to fend off potential fraud claims based on statements made in negotiations; targets should avoid such language or conduct additional due diligence and/or get added clarity if fraud or misrepresentation is a concern.

  4. Be conscious of whether statements made in negotiations are something other than future promises, and if certain conduct or expectations are important to you, ensure that they make it into writing.

Copyright © 2021, Sheppard Mullin Richter & Hampton LLP.National Law Review, Volume XI, Number 168
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About this Author

John Stigi securities law  corporate attorney Sheppard Mulli, law firm
Partner

John Stigi is a partner in the Business Trial Practice Group in the firm's Century City and New York offices, and leader of the firm's Corporate/Securities Litigation Team.

Mr. Stigi's practice focuses on securities class action and shareholder derivative action defense, SEC investigation defense, internal corporate investigations, complex contract and commercial litigation, and M&A and corporate governance litigation.  He has extensive experience representing issuers, officers, directors and auditors in all areas of securities, corporate...

310-228-3717
Eugene Choi Orange County Corporate Lawyer Sheppard Mullin Law Firm
Associate

Eugene Choi is an associate in the Corporate Practice Group in the firm's Orange County office. 

Areas of Practice

Eugene's practice encompasses a variety of corporate and securities matters, including mergers and acquisitions, public and private securities offerings, private equity, venture capital financing, business formation and structuring, joint ventures, and corporate governance matters.

He previously served as a law clerk to the Honorable Karen L. Valihura of the Delaware Supreme Court.  He is a Chartered Alternative Investment Analyst (CAIA...

714-424-2834
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