Earnout Decision Underscores Buyer’s Post-Closing Obligations Are Very Limited Except as Specifically Set Forth in Parties’ Agreement—Fortis v. Medtronic

In Fortis v. Medtronic Minimed (July 29, 2024), the Delaware Court of Chancery, at the pleading stage of litigation, dismissed claims against Medtronic Minimed, Inc. for, allegedly, having purposefully defeated a $100 million earnout payment (the "Milestone Payment"). The Merger Agreement, pursuant to which Medtronic had acquired Companion, Inc. for over $300 million, required that, post-closing, Medtronic not take action with the primary purpose of defeating the earnout.

Key Points

• The decision reinforces that, under Delaware law, except as expressly set forth in the parties' agreement, a buyer has very limited obligations to take action to support achievement of an earnout. Unless the parties' agreement provides otherwise, Delaware law generally requires only that a buyer not take action with the specific purpose of defeating an earnout. The Court held that the standard in the Merger Agreement in this case imposed an even narrower obligation-with Medtronic permitted to take actions motivated by defeating the earnout so long as some other purpose was "more central" to Medtronic's decision.
  
  
• The decision thus highlights the need for particular care in drafting a buyer's post-closing obligations with respect to an earnout. While the standard in this case may have been intended to parrot the general Delaware law standard, including the word "primary" rendered it significantly narrower. Further, parties should also consider carefully whether to include in their agreement, in respect of an earnout, business-contextualized covenants, listing specific actions that must or may, or that cannot, be taken by the buyer (or by the seller) post-closing.
  
  
• The factual context was unusual. The case was unusual in that the Merger Agreement set forth what the Court called an "exceptionally buyer-friendly standard" for the buyer's post-closing obligations with respect to the earnout; and in that, notwithstanding that the standard depended on the buyer's "primary purpose" for its actions, in the Court's view the Plaintiff did not plead allegations relating to Medtronic's purpose in taking the actions that led to the earnout milestone not being met. We note that the Court recently has been more often finding in favor of sellers claiming entitlement to earnout claims than was the case historically. Importantly, however, in each case, the Court has focused on the specific agreement language and the overall circumstances-which generally makes it difficult to predict the outcome of earnout cases.

Background. Medtronic operated a "Diabetes Unit" for its parent company. Prior to the Medtronic-Companion merger (the "Merger"), Companion had developed two "smart insulin pen" products (InPen and InCap). On July 24, 2020, the Merger Agreement was executed. The Merger Agreement provided for Medtronic to pay the Milestone Payment if Medtronic sold at least 85,000 smart insulin pens for an average price of at least $400 each during any four consecutive quarters during the eight full quarters following the closing (the "Milestone Period"). The Merger closed on September 19, 2020. The post-closing sales did not meet the milestone threshold, and Medtronic did not pay the Milestone Payment. The Plaintiff (Fortis Advisors, LLC, in its capacity as Stockholders' Representative for the former Companion stockholders) brought suit. At the pleading stage, Judge Meghan A. Adams (sitting by designation as a Vice Chancellor) granted Medtronic's motion to dismiss the claim relating to the earnout. Separately, she declined to dismiss an unrelated claim seeking the release to former Companion stockholders of certain funds held in escrow.

Discussion

The Merger Agreement earnout provision. Section 2.11(f) of the Merger Agreement stated that: Medtronic will develop and sell the Milestone Products "in accordance with its own business judgment and in its…sole discretion"; Medtronic will not rely on any conversations or writings the parties may have engaged in before signing; and Medtronic will not have "any liability whatsoever" for any claim arising out of or relating to "any decisions or actions affecting whether or not or the extent to which the Milestone Consideration becomes payable." Most relevant to the case, this language was qualified by the following: "Notwithstanding the foregoing, until the end of the Milestone Period, Buyer shall not take any action intended for the primary purpose of frustrating the payment of Milestone Consideration hereunder."

The Plaintiff claimed that Medtronic's actions, and failures to act, had the primary purpose of defeating the earnout. Both parties acknowledged that Section 2.11(f) of the Merger Agreement "immunized Medtronic from any milestone-related claims aside from a claim that Medtronic acted for the primary purpose of frustrating [achievement of the Milestone Payment]." The Plaintiff asserted that Medtronic acted with the primary purpose of defeating achievement of the Milestone Payment by:

• Requiring the legacy Companion salespeople to sign non-compete agreements that temporarily precluded subsequent employment in "the diabetes field," which led to an exodus of the top salespeople-although, allegedly, prior to closing, Medtronic had stated that such agreements would be limited in scope to "the field of smart insulin pens";
• Not replacing the legacy Companion salespeople who resigned;
• Not incentivizing Medtronic's own salespeople to sell InPens until spring 2021 (although the Milestone Period began in November 2020);
• Even once Medtronic incentivized its own sales team to sell InPens, not offering powerful enough incentives to them (and in any event they did not have enough experience with InPens);
• Deferring commencement of a $12 million marketing program, that had been discussed pre-closing and that would have supported sales of the InPen during the Milestone Period-and instead instituting the marketing program the month after the Milestone Period expired; and
• Refusing to pursue InCap "clearance and sales…under the guise of Medtronic's belief that insurers would not cover InCaps often enough to make pursuing InCap sales worthwhile"-while, in Fortis's view, it was reasonable to assume that the InCap product would have been covered more than 50% of the time given Companion's pre-closing ability to obtain coverage for InCaps.

The Court held that, under the Merger Agreement, Medtronic could act in ways intended to defeat the Milestone Payment so long as defeating it was not the primary purpose. The Court noted that Medtronic did not covenant to use best efforts, commercially reasonable efforts, or even good faith efforts to achieve the Milestone Payment. Rather, it had "secured for itself sole discretion to take actions that [it] knew would frustrate the [Milestone Payment], so long as the action had some other primary purpose." And, in an arm's-length transaction, "Fortis freely assented to that arrangement." Therefore, even though, for example, the expected marketing program was instituted just after the Milestone Period ended, and the Court found it reasonable to infer therefrom that Medtronic "was content to let the [Milestone Payment condition] go unmet," it was not inferable, the Court held, that Medtronic's primary purpose in deferring the marketing program was to defeat the earnout. The Court stressed that "Medtronic had no contractual duty to make any effort to achieve the [earnout]"; its "only obligation was to refrain from actions primarily aimed at frustrating the [earnout]." (The Court noted that it was "not aware of any Delaware precedent applying such a buyer-friendly contingent payment scheme," and that the parties had cited none.)

The Court drew a distinction between Medtronic acting to defeat the earnout and failing to actto help meet the earnout. The Court noted that Section 2.11(f) only "expressly proscribe[d] affirmative acts." The Plaintiff, the Court observed, fashioned Medtronic's alleged failures to act as affirmative actions-for example, alleging that Medtronic deferred the introduction of new salespeople, deferred the marketing program, and refused to pursue InCap clearance and sales. Notwithstanding that "artful wording," the Court stated, given that the Merger Agreement only expressly proscribed affirmative acts, the relevance of failures to take action was "at best, questionable."

The Court found the Plaintiff pled no facts as to Medtronic's purpose in taking the actions the Plaintiff complained of. That failure took on "outsized importance in light of the atypical deference Section 2.11(f) [gave] to Medtronic," the Court stated. The Court acknowledged that a plaintiff might not be able to offer direct evidence of a buyer's primary purpose, but here, the Court stressed, the Plaintiff had not offered even "circumstantial evidence of an action's purpose aside from conjecture based only upon the action itself." The Court wrote: "[I]t is not as if Section 2.11(f)'s requirements made it impossible to sufficiently plead a breach of Section 2.11(f) absent direct evidence of Medtronic's purpose. Fortis simply did not do so."

The Court offered examples of the kinds of circumstantial evidence that might support an inference of a primary purpose to defeat an earnout. The Court stated that Medtronic's actions-such as requiring non-compete agreements and not providing compelling sales incentives-might have been "more suspect" if these policies had applied only to the legacy Companion business, as that "would tend to suggest that [the] actions had more to do with frustrating the [earnout] than another business purpose." But, the Court stated, the Plaintiff did not allege that Medtronic treated the legacy Companion products differently than any other Medtronic assets. Also, the Court stated that the timing of Medtronic's actions "could help raise an inference of a primarily improper purpose"-if, for example, the non-compete agreements had been "abruptly forced" on the legacy Companion employees or the reduction in sales incentives for InPens had been imposed only when Medtronic had gotten close to achieving the earnout. But, the Court stated, the Plaintiff's allegations reflected instead that "Medtronic largely maintained the status quo throughout the Milestone Period" (with the only exception being the request for non-compete agreements, which Medtronic made shortly after acquiring Companion and before the Milestone Period began). Indeed, the Court noted, the only mid-Milestone Period change Fortis alleged was that Medtronic started incentivizing the sale of InPens about one-quarter of the way through the Milestone Period. With respect to Medtronic's starting the marketing program just after the end of the Milestone Period, the Court emphasized that Medtronic had no contractual duty to make any effort to achieve the First Milestone-it could have, but it did not, negotiate for required marketing investments during the Milestone Period, the Court noted.

Practice Points

• Define the business deal relating to post-closing obligations to support an earnout. Where the parties are silent as to the buyer's post-closing obligations relating to supporting achievement of an earnout, the buyer's obligations under Delaware law is likely to be quite limited. Where the parties address such obligations in their agreement, they should consider including provisions that are highly tailored to the specific company, business, industry, products, and circumstances at issue. The general standard for a buyer's commitments post-closing can vary widely and should be well-defined. For example, in addition to defining the general standard, as well as any specific actions of kinds of actions that the buyer must, can, or must not take, a buyer may wish to provide that any action it takes that has a plausible business reason will be deemed not to have been taken with an intent to frustrate the earnout.
  
  
• Tailor post-closing obligations to the particular context. These should not be boilerplate or standardized provisions, but, with input from the business people who know the company best, contextualized for the specific situation. Such provisions should cover, for example, the aspects of the post-closing operations that are the most critical to the acquired business's operations or to the achievement of the earnout, or those areas that may be most subject to manipulation or dispute. If the parties have discussed post-closing plans, or particular actions that would have to be taken to maximize the potential of achievement of the earnout, the seller should keep in mind that those actions may not have to be taken unless a commitment to take them is set forth in the agreement.
  
  
• Consider, and specify, whether the post-closing actions the buyer can take relate to the acquired business only or to the buyer's entire business. Actions taken that relate to the acquired business only may be more suspect in terms of a motivation to defeat the earnout. A buyer also should be sensitive to the timing of actions it takes that may negatively impact achievement of an earnout. Actions that are taken "abruptly" or just as the earnout is getting close to being achieved may be more suspect in terms of a motivation to defeat the earnout.
  
  
• A buyer should maintain a record of the business reasons for actions it takes during the earnout period that may negatively affect the earnout. The Delaware courts have tended not to view actions as having been taken for the purpose of frustrating payment of an earnout if: (i) there was any basis for the actions to be viewed as legitimate business decisions and for the sellers' complaint to be viewed simply as a dispute concerning business strategy, and/or (ii) there were countervailing factors indicating other efforts by the buyer to support the relevant business (for example, the investment of funds in the business, hiring of additional sales people for it, and so forth). Accordingly, buyers should maintain a record of the business reasons for their post-closing actions that may negatively affect achievement of an earnout, as well as a record of the actions they take that support achievement of the earnout.
  
  
• A seller may want to specify rights that it will have post-closing to support achievement of the earnout. This may be advisable particularly where the seller will remain involved in the business post-closing. A key consideration would be the extent to which notice to or control by the buyer would be required with respect to actions the seller is permitted to take.
  
  
• Keep in mind that the law of other states varies. The law in some states, for example, imposes an implied obligation on the buyer to take "reasonable efforts" to achieve an earnout, at least in the absence of an express disclaimer to the contrary.
  
  
• Consider an alternative dispute resolution mechanism. Given the prevalence of earnout disputes, parties should consider providing for an alternative dispute resolution mechanism, such as arbitration.

• See also our recent Briefing, Earnouts Update 2023.

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