Delaware Law Alert: Efforts Standards in Life-Sciences Earnout Provisions

In two significant recent opinions, the Delaware Chancery Court ruled against the buyers of life sciences companies, holding that they failed to apply commercially reasonable efforts to achieve earnout milestones. In Fortis Advisors LLC v. Johnson & Johnson,¹ the court awarded nearly $1 billion in damages for breach of contract to the target company’s stockholders, while the court in Shareholder Representative Services LLC v. Alexion Pharmaceuticals, Inc.² will announce its damages determination in a separate opinion. The opinions highlight the perils associated with negotiating and interpreting diligence obligations of this kind—which are prevalent in life sciences M&A transactions—as well as licensing and collaboration agreements.

The Opinions

Fortis Advisors LLC v. Johnson & Johnson

• The Agreement: The merger agreement in the Johnson & Johnson (J&J) case required the buyer to use commercially reasonable efforts (CRE) to achieve various development and commercial milestones in respect of the acquired company’s surgical robots, which milestones were linked to up to $2.35 billion in deferred merger consideration. This obligation utilized a detailed, “inward-facing” CRE definition which committed the buyer to using commercially reasonable efforts consistent with its “usual practice” with respect to “priority medical device products of similar commercial potential at a similar stage in the product lifecycle.” The definition went on to list ten factors the buyer could take into account in determining what level of efforts would be appropriate. In addition, the definition contemplated pursuit of regulatory clearance for the products through a specific Food and Drug Administration (FDA) pathway—namely, pursuant to Section 510(k) of the Food Drug and Cosmetic Act—and also prohibited the buyer from taking into account the cost of the earnout payments.
• The Dispute: The plaintiff, the representative of the former shareholders of the target, argued that the buyer breached its diligence obligation, thereby destroying any opportunity to achieve the milestones and to allow the selling shareholders to receive the associated milestone payments. To support its case, the plaintiff pointed to a number of actions taken by the buyer. These included, notably:

• Subjecting one of the acquired robots, iPlatform, to a competition with a competing robot that the buyer had been developing, thereby disrupting iPlatform’s progress towards regulatory clearance;
• After iPlatform prevailed in the competition, integrating the incumbent robot platform and team with the iPlatform program and team, creating further disruption and delay;
• Implementing an employee-incentive program with incentives that differed from the milestone criteria and that had longer timelines than the milestone criteria; and
• Writing off the iPlatform milestones following the FDA’s determination that robots of its kind would no longer be eligible for regulatory clearance through the 510(k) pathway.

The buyer asserted various defenses grounded in its interpretation of the merger agreement’s CRE obligation. It argued that the complained-of conduct was consistent with the discretion afforded to it by the CRE definition and that some of the complained-of actions were supportive of, rather than counter to, iPlatform’s achievement of the regulatory milestones. The buyer also argued that the milestones predicated on regulatory approval were no longer capable of satisfaction following the FDA’s policy change precluding use of the 510(k) clearance pathway, because the CRE definition tied the efforts standard to obtaining regulatory approval through the 510(k) pathway.

• The Court’s Analysis: The court engaged in a lengthy and detailed analysis of the factual record, the CRE definition in the merger agreement, and its application to the buyer’s activities in relation to the iPlatform program. Based on that analysis, the court concluded that the actions noted above constituted a breach of the buyer’s diligence obligations insofar as they were not consistent with the efforts that the buyer would be expected to use in relation to a priority medical device.

Notably, the court addressed the change in the FDA’s policy precluding use of the 510(k) clearance pathway for iPlatform by determining that (i) there was no evidence that the parties had specifically bargained for achievement of the milestones predicated on regulatory clearance through that specific regulatory pathway, but rather, appeared to simply contemplate the anticipated route to regulatory clearance at the time the merger agreement was negotiated, which happened to be the 510(k) pathway; and (ii) Delaware law’s implied covenant of good faith and fair dealing required the buyer to apply efforts to achieve regulatory clearance via the alternative route dictated by the FDA’s policy change—the de novo pathway.

Having found the buyer liable for breach of contract, the court used an analysis based on the probability of achieving the various milestones prior to entry into the merger agreement. Applying that methodology, the court awarded damages of nearly $1 billion in respect of those claims.

Shareholder Representative Services LLC v. Alexion Pharmaceuticals, Inc.

• The Agreement: The Alexion case involved a merger agreement that contemplated an earnout of up to $800 million, spread over eight possible payments, to the former shareholders of Syntimmune, Inc. upon achievement of various milestones based on the development, regulatory approval, and commercial success of a monoclonal antibody product. The buyer was obligated to use commercially reasonable efforts to achieve the milestones over a seven-year period. In this case, the CRE definition contemplated an “outward-facing” standard, in that it required the buyer to use efforts and resources typically used by biopharmaceutical companies similar to the buyer for a product at a similar stage of development, taking into account certain listed factors.

• The Dispute: The parties’ disagreement involved two main issues. The first was a dispute over whether the first milestone had been met, which would have involved satisfying several criteria indicating successful completion of a Phase I clinical trial. This aspect of the dispute centered on the parties’ divergent views of how the criteria specified for satisfaction of the milestone should be interpreted.

The second issue involved the plaintiff’s assertion that the buyer had failed to use commercially reasonable efforts in satisfying the remaining seven milestones. The plaintiff identified three actions that it asserted were breaches of the buyer’s obligation to use commercially reasonable efforts in relation to the development of the acquired product: (1) the buyer’s decision to deprioritize development of the product; (2) its decision to abandon development of an intravenous formulation of the product; and finally, (3) its decision to discontinue development of the product. The plaintiff argued that these decisions were motivated by an internal effort on the buyer’s part to reduce costs in the wake of its own acquisition by AstraZeneca and by an effort to launch ten new products by 2023, and not by determinations of what efforts would be commercially reasonable to use in achieving the specified milestones for the acquired product.

• The Court’s Analysis: After concluding that the first milestone had been satisfied, the court addressed the question of whether the buyer had used commercially reasonable efforts to achieve the remaining milestones, engaging in a detailed review of the record and of the various elements of the merger agreement’s CRE definition. The court began by considering how to approach the outward-facing standard contemplated by the CRE definition. It considered whether a “yardstick approach” that looked to other exemplar companies would be a suitable method for applying such a standard, but concluded that there were no adequate exemplar companies that operated under the same conditions as the buyer. As a result, the court determined that it was necessary to instead consider the buyer’s actions in comparison to what a hypothetical typical company of the buyer’s size would do with a comparable product. In applying this standard, the court relied upon an assessment of what the buyer’s competitors had done with respect to competing products, expert opinions, and a comparison of the efforts that the buyer used and the factors it considered at relevant points in time.

The court assessed each of the plaintiff’s asserted breaches of the diligence obligation in the context of the various elements of the merger agreement’s CRE definition in turn, testing each within its rubric of considerations for assessing what a hypothetical similarly situated biopharmaceutical company would do. In the end, the court concluded, based on its holistic assessment of the points it considered, that the buyer’s decisions to deprioritize the acquired product—and to thereafter terminate its development—fell short of its obligation to use commercially reasonable efforts to achieve the remaining seven milestones under the merger agreement. The trial record supported the conclusion that the buyer’s decisions were designed to support an “idiosyncratic corporate initiative” designed to achieve merger synergies after the buyer was acquired. The court went on to hold that the breach resulting from the buyer’s termination of the development program caused harm to the plaintiff and thus supported liability. The court left its determination of damages to a subsequent opinion.

Takeaways

• The Long Life of Diligence Obligations: These cases demonstrate the long life that diligence obligations can have after the parties have closed an acquisition that involves an earnout. Their lessons should be understood as equally relevant for other transactions involving deferred consideration, particularly the kinds of licensing and collaboration transactions that are so prevalent in the life sciences industry. Whenever such diligence obligations are present, it is imperative that the acquiror remain mindful of them in the context of its ongoing efforts with respect to the acquired business or product. Material decisions or inflection points should be occasions to revisit and carefully consider the language of the obligations and associated CRE or other efforts definitions.

• Limitations of Efforts-Based Obligations: The CRE definitions in the agreements involved in both the J&J and Alexion cases were painstakingly negotiated and carefully drafted. The subsequent disputes demonstrate that it is impossible to anticipate every twist and turn that can arise after closing, and thus the inherent limitations of CRE-based diligence obligations. This uncertainty is often unavoidable, but when possible, parties are more likely to benefit from more objective metrics to determine when deferred consideration will be payable.

• Implied Covenants and Unanticipated Changes: In the J&J case, the court’s approach to interpreting the CRE definition, in light of the FDA’s post-closing policy change, suggests that parties should be cautious when interpreting their obligations after an external change renders some aspect of the contractual language technically incapable of performance. In that case, the CRE definition contemplated regulatory clearance through the 510(k) pathway, which pathway was foreclosed for devices like iPlatform by a post-closing FDA policy change. The court effectively disregarded the reference to the 510(k) pathway in the CRE definition, concluding that—in the absence of a clear indication that the parties specifically bargained to pursue the 510(k) pathway and no other—the implied covenant of good faith and fair dealing required the parties to pursue another pathway still available after the policy change.

• Inward-Facing and Outward-Facing Standards: These cases generally support the view that inward-facing standards in CRE definitions afford more certainty for acquirors than outward-facing standards. But these cases demonstrate that there can be pitfalls in either approach, and that interpretation of a party’s actions in both cases will depend heavily on the details of the CRE definition and corresponding obligations. In any case, acquirors must be mindful of the context in which decisions bearing on an earnout are made and what other potential motivations might be ascribed to them in hindsight. Acquirors should also recognize that even lengthy lists of factors that they are entitled to take into account—when determining whether or not they are complying with a CRE-based obligation—may not permit them to consider matters that are extrinsic to the acquired product or business. As the court pointed out in both cases, the buyer’s actions where “cabined” by what was appropriate for the acquired product. If an acquiror expects to be able to take actions based on considerations unrelated to what’s best for the product or business that is the focus of the earnout, it is important that it bargain for and document that right.

• Existing Earnouts Complicated Later Deals: The Alexion case demonstrates the complexities that can arise when an acquisition target has an ongoing commitment to use a specific level of efforts to achieve objectives linked to payment obligations owed to sellers or licensors in other transactions. The court concluded that the buyer’s actions were driven by its objective to achieve synergies resulting from its merger with AstraZeneca, and not by what was necessary to meet its efforts obligations to the Syntimmune shareholders. Acquirors should carefully assess these kinds of obligations when considering an acquisition and ensure that they do not lose sight of them post-acquisition.

¹ C.A. No. 2020-0881-LWW (Del. Ch. September 4, 2024, Will, V.C.). The Fortis Advisors decision also included fraud claims, which are beyond the scope of this discussion.

² C.A. No. 2020-1069-MTZ (Del. Ch. September 5, 2024, Zurn, V.C.).