In Fortis Advisors LLC, as the equity representative v. Dialog Semiconductor PLC, the Delaware Court of Chancery examined the implied covenant of good faith in the context of an earn-out provision included in a merger agreement.

The merger agreement included the following provision: “From the Closing Date through the end of the Second Earn-out Period, Parent shall, and shall cause its Affiliates . . . to, use commercially reasonable best efforts, in the context of successfully managing the business of the Surviving Corporation, to achieve and pay the Earn-Out Payments in full . . .”

As one might surmise, no payments became due under the earn-out. We typically advise clients “don’t agree to an earn-out unless the up-front payments are sufficient.”

The court noted that under Delaware law, the implied covenant of good faith and fair dealing attaches to every contract by operation of law and requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain. The implied covenant only applies where a contract lacks specific language governing the issue and the obligation the court is asked to imply advances, rather than contradicts, the purposes reflected in the express language of the contract.

The court found the allegations of the complaint failed to state a claim for breach of the implied covenant of good faith and fair dealing because Fortis had not identified, as it must, a gap in the merger agreement to be filled by implying terms through the implied covenant. The Merger Agreement expressly imposed on Dialog the obligation to use “commercially reasonable best efforts to . . . achieve and pay the Earn-Out Payments in full.” Thus, the merger agreement set a contractual standard by which to evaluate whether Dialog’s failure to achieve and pay the earn-out payments in its operation of the business was improper. Accordingly, there was no gap in the merger agreement for the court to fill.