American Capital Acquisition Partners, LLC v. LPL Holdings, Inc.
(Del. Ch. February 3, 2014) (denying in part a buyer's motion to dismiss a claim for breach of the implied covenant of good faith and fair dealing, which arose, allegedly, from affirmative steps by the buyer to impede revenue generation by the target business and thus evade "earnout" obligations payable to selling stockholders)
The Delaware Chancery Court recently reviewed the application of the implied covenant of good faith and fair dealing in connection with "earnout" provisions in an acquisition agreement. In American Capital Acquisition Partners, LLC v. LPL Holdings, Inc., the court allowed a claim for a breach of the implied covenant to survive a motion to dismiss but made an important distinction among the specific plaintiff claims. Claims that survived the motion to dismiss were based on allegations that the buyer had actively diverted clients, personnel and other opportunities away from the acquired business to its other businesses (that were not part of the earnout), purposefully impeding the ability of the target business to meet the financial metrics required for receipt of the additional "earnout" consideration payable pursuant to the purchase agreement. The court did not apply the same review to the plaintiff's claims that the buyer should have made proactive adaptations to the acquired business platform in order to increase the likelihood of achieving additional revenue milestones. In summary, the court has helped to clarify that the implied covenant of good faith and fair dealing compels a buyer to refrain from actively depressing or undermining payment of a contingent purchase price payment. However, the buyer is not, under the implied of good faith and fair dealing, obligated to proactively maximize opportunities to achieve the contingent "earnout" consideration.
Notably, plaintiffs argued that the implied covenant of good faith and fair dealing should apply to matters addressed during negotiations and "expected" by the parties. In this instance the parties discussed during negotiations certain technological adaptations of the buyer's systems that would create synergies and potentially generate revenue for the target business. However, the parties did not contract for any specific adaptations in the purchase agreement and, following the closing, the buyer chose not to make any of the potential adaptations. The court did not extend the application of the implied covenant of good faith and fair dealing this far, holding that the covenant "serves [as] a gap-filling function by creating obligations only where the parties to the contract did not anticipate some contingency, and had they thought of it, the parties would have agreed at the time of contracting to create that obligation." The court also cited the integration clause in the purchase agreement, which made it clear that the parties had not made any additional promises or covenants other than those set forth in the agreement.
This case highlights the importance for sell side practitioners to include affirmative and specific buyer obligations in earnout provisions as may be required in order to meet contingent consideration objectives. Buy side practitioners must also be mindful that unless the agreement includes an affirmative covenant of the buyer to act in good faith or disclaims the implied covenant of good faith and fair dealing, the buyer's post-closing conduct during any "earnout" period will be subject to potential judicial scrutiny (with the benefit of hindsight) for compliance with the covenant of good faith and fair dealing and buyer's should consider how they document business decisions that may impact whether an earnout is achieved.