We keep a close eye on developing cases regarding earn-outs and contingent payment rights in light of the prevalent use of these arrangements in life sciences deals and their increasing use in non-life sciences deals. On September 8, 2016, a federal court in New York declined to dismiss a claim that Sanofi breached its efforts obligations in connection with contingent value rights (CVRs) granted as part of the merger consideration for Sanofi’s $18+ billion (initially hostile) acquisition of Genzyme in 2010. The CVR holders claimed that Sanofi failed to use the required efforts to achieve the drug approval and promotion milestones that were contained in the acquisition agreement, which they said caused Sanofi to miss up to $708 million in CVR payments to the holders. The court found that the Trustee on behalf of the CVR holders pled sufficient facts to raise a reasonable inference that Sanofi breached its agreement to use “diligent efforts,” but dismissed the holders’ implied covenant of good faith and fair dealing claim, finding it redundant with the breach of contract claim under New York law. Although this decision is in the context of a motion to dismiss (and may ultimately be decided in favor of the defendants), it provides an example of a court’s willingness to enforce a contractual provision requiring a buyer to adhere to its promise to expend “diligent efforts” to achieve drug approval and sales milestones in the context of a contingent payment right.

Here’s a summary of the specific holding:

At the time of the merger, Genzyme had been conducting clinical trials on Lemtrada, a promising multiple sclerosis drug. Under the CVR agreement, Sanofi agreed to use “diligent efforts” – defined as “using such efforts and employing such resources normally used by Persons in the pharmaceutical business . . . .” – to achieve certain regulatory approval and sales milestones by specified dates. According to the complaint, Sanofi breached the CVR agreement because it purposely delayed Lemtrada’s drug approval and failed to market Lemtrada in the same way that it marketed other drugs, including its drug Aubagio, a competing MS drug that Sanofi owned but that was not subject to similar milestone payments. Specifically, the complaint alleged that Sanofi “embarked on a slow path to FDA approval and departed from its own drug commercialization patterns and those of others in the industry.” The court found that the following allegations were sufficient to plead a breach of the defendant’s “diligent efforts” covenant:

  • The CVR agreement contained an approval milestone based on FDA approval of Lemtrada for MS treatment by March 31, 2014. Plaintiff alleged that even though the FDA had previously expressed concerns with the neutrality of the clinical trials for Lemtrada, Sanofi proceeded to conduct the trials using an open-label, rater-blind Phase III trial, instead of the FDA-preferred, double-blind methodology. The plaintiff also alleged that Sanofi waited until one month after the milestone deadline to submit requested, supplemental paperwork addressing the FDA’s concerns even though it knew about those concerns well ahead of time.
  • The first sales milestone required that the sum of Lemtrada sales for certain markets would surpass $400 million by June 30, 2016. The court found that the complaint sufficiently alleged that Sanofi breached its required diligence efforts because it responded inadequately to the FDA’s drug safety concerns, which led to Lemtrada’s approval as merely a third-line therapy for MS, thereby limiting drug sales. Moreover, the plaintiff alleged that in contravention of industry practice (and Sanofi’s own marketing and promotion efforts for Aubagio), Sanofi delayed assembling a Lemtrada salesforce, failed to provide doctors with sufficient drug information, failed to develop infusion centers to ensure patient access to the drug and failed to operate patient resource campaigns. The complaint further alleged that Sanofi manipulated sales in qualifying markets in order to extend the measuring period for an evaluation of the drug’s revenues.

Efforts covenants are commonly requested by sellers in deals where an earn-out or contingent payment comprises part of the merger consideration. Because the payments are often based on the operation or financial performance of the acquired business after closing, a seller will often request that a buyer undertake obligations as to how the buyer will operate the business that it now owns. In private deals, where contingent payments are more commonly used, recent studies have suggested a decrease in the prevalence of efforts covenants overall where there is an earn-out, despite the fact that the number of private deals using earn-outs in general continues to increase. According to recent case law in Delaware, buyers do not have an independent obligation under the implied covenant of good faith and fair dealing to try to maximize value or pay an earn-out if a contract’s plain language does not require it to do so, which suggests that well-advised sellers should include express efforts covenants in the acquisition agreement. The existence in this case of a readily available comparison (Sanofi’s simultaneous approval and sale of its competing drug, Aubagio) may distinguish the facts here from other situations where a buyer could more easily argue that it acted in good faith with respect to its efforts covenant. However, the ruling demonstrates that a court (under New York law) is at least willing to dive deeper into the factual record to enforce an express operational covenant to achieve milestone payments. As CVRs and earn-outs are increasingly being suggested by financial advisors and industry participants to bridge valuation gaps at signing, sellers should continue to request these express efforts covenants to protect the benefits of their bargain after closing. Buyers, on the other hand, may cite this case as a reason to resist them.