Delaware Law Alert: Conditions Precedent Under the Microscope—Key Lessons for M&A Agreements

In Thompson Street Capital Partners IV, L.P. v. Sonova United States Hearing Instruments, LLC,¹ the Delaware Supreme Court recently adopted a complex framework for determining when noncompliance or partial compliance with a condition precedent in M&A agreements may be excused. The analysis involves an assessment of (1) whether the language in the agreement clearly and unambiguously triggers forfeiture of a contract right if a condition is not met, and (2) if the condition is not a material part of the agreement, whether the potential forfeiture due to noncompliance would be disproportionate in comparison to the potential harm to the other party if the condition were excused. Although the case deals specifically with an indemnification claim notice that did not comply with all the requirements set forth in a merger agreement, the analysis can apply equally to other M&A agreement conditions. This Legal Update discusses the analysis and offers practical takeaways.

Background

The buyer, Sonova United States Hearing Instruments, LLC, acquired certain audiology practices from Alpaca Group Holdings, LLC, with Thompson Street Capital Partners IV, L.P. acting as the representative of the former members of Alpaca Group. The merger agreement contemplated a $7.75 million indemnity escrow designated as the exclusive post-closing remedy for breaches of the sellers’ representations and warranties. The merger agreement and escrow agreement conditioned any recovery on the buyer’s delivery of a detailed written notice specifying each breached representation, attaching supporting evidence, and providing an estimate of damages. At issue was whether the buyer’s indemnification claim notice, which was delivered to the sellers’ representative and the escrow agent one business day before the expiration of the survival period, was valid even though it did not strictly follow the notice requirements of the merger agreement. The Delaware Chancery Court found the notice sufficient and dismissed the claims, but the Delaware Supreme Court reversed and remanded the case for additional proceedings to evaluate whether the notice requirement was material and whether any non-compliance should bar the buyer’s ability to recoup from the deal’s multimillion dollar escrow—its sole source of recovery.

Specifically, in its indemnification claim notice, the buyer (1) asserted that it had discovered improper billing and reimbursement practices in violation of the sellers’ representations and warranties, and (2) directed the escrow agent to reserve the entire amount of the escrow fund since the buyer could not yet quantify damages with certainty.

The sellers’ representative alleged that the buyer’s notice failed to meet two particular requirements under the merger agreement:

• The merger agreement required the claim notice to “include copies of all available material written evidence” supporting the claim. The sellers’ representative alleged that, although the notice described the buyer’s investigation, it did not provide any supporting written evidence

• The merger agreement also required that the buyer deliver the claim notice reasonably promptly, and in any event, not later than 30 days after the buyer actually became aware of the claim. Delay in delivering notice would not relieve the sellers of their indemnification obligations, except to the extent that the delay “actually and materially prejudice[d]” the sellers. The sellers’ representative alleged that the buyer was aware of facts underlying their claims for more than a year before delivering the notice and that the buyer’s delay materially prejudiced them by increasing the risk of excess damages, negating the parties’ ability to negotiate with third-party payors, and potentially extending the period of non-compliance and related damages.

In addition, the merger agreement provided that if the buyer failed to notify the sellers’ representative in accordance with the notice procedures set forth in the agreement, it would “have no right to recover any amounts pursuant to” the indemnification provision. The sellers’ representative sought declaratory judgment that the notice was defective and could not serve as a basis to withhold the escrow fund and also sought specific performance or a mandatory injunction to cause the buyer to join an instruction letter directing the escrow agent to release the funds.

As described in more detail below, the Delaware Supreme Court reversed the Chancery Court’s dismissal and remanded the case for further proceedings.

A Framework for Interpreting Conditions Precedent and Disproportionate Forfeiture

While not the first time Delaware courts have reviewed the effect of a condition precedent and the circumstances under which compliance may be excused as a “disproportionate forfeiture” of a contractual right, the opinion offers a systematic approach that clarifies many aspects of the analysis, particularly as applied to M&A indemnification claims and M&A agreements generally.

The Court’s framework is derived largely from the Restatement (Second) of Contracts (the “Restatement”), which states the operative principle as follows: “To the extent that the non-occurrence of a condition would cause disproportionate forfeiture, a court may excuse the non-occurrence of that condition unless its occurrence was a material part of the agreed exchange.” The principle seeks to address situations in which a nonconsequential failure in complying with a condition precedent results in the forfeiture of a significant contractual right.

While the Restatement articulates the principle in simple terms, the Court’s analysis and application of the facts in practical terms was complex. The Court proceeded as follows:

1. When is a notice requirement a condition precedent to the buyer’s indemnification rights?

The Court explained that a condition precedent is an act or event that must occur before a duty to perform arises. Put differently, compliance with a condition precedent by one party requires the other party to perform. Because failure of a condition precedent may result in the loss of rights (referred to as a forfeiture), the condition must be stated clearly and unambiguously. The Court concluded that the indemnification notice requirements were a condition precedent to the buyer’s indemnification rights because the requirements were clearly stated and supported by a consequence: failure to comply would result in the buyer having “no right to recover any amounts pursuant to” the indemnification provision.

2. Did the buyer comply with the condition precedent?

At the pleading stage, the Court found that it was reasonably conceivable, based on the allegations of the sellers’ representative, that the buyer failed to comply with the indemnification notice requirements in two ways. First, the Court found that the buyer, by its own admission at oral argument, had not “include[d] copies of all available material written evidence” of its claim with its claim notice as required by the agreement. Indeed, the buyer conceded that it had not attached any documentation to its claim notice, though it argued there were “practical reasons for that.” Second, the Court found that the sellers’ representative had adequately pleaded that the buyer failed to send its notice within 30 days of becoming aware of its claim for indemnification and that it was plausible that such delay “actually and materially prejudice[d]” the sellers.

3. Was the condition “a material part of the exchange” such that non-compliance should result in mandatory forfeiture of indemnification rights?

Having determined the condition precedent was not satisfied, the Court next considered whether the condition could be excused. The Restatement approach adopted by the Court takes the position that noncompliance may be excused only if the condition was not a material part of the exchange. In other words, if the notice requirements were material to the buyer’s and sellers’ exchange, then the buyer’s failure to comply would result in mandatory forfeiture of the indemnification right.

The Court held that the factual record was inadequate to determine materiality and remanded to the Chancery Court to resolve the issue. The Court offered a few analytical guideposts, but ultimately left the question to the lower court to resolve.

First, the opinion refers to a list of factors found in the Restatement that courts may consider in addressing materiality and directs the Chancery Court to the factors “[t]o be as helpful as possible.” Those factors are:

• The extent to which the injured party will be deprived of the benefit which he reasonably expected
• The extent to which the injured party can be adequately compensated for the part of the benefit of which he will be deprived
• The extent to which the party failing to perform or to offer to perform will suffer forfeiture
• The likelihood that the party failing to perform or to offer to perform will cure his failure, taking account of all the circumstances including any reasonable assurances
• The extent to which the behavior of the party failing to perform or to offer to perform comports with standards of good faith and fair dealing.

Second, the Court noted that materiality depends on a number of factual considerations, “rest[ing] to a large extent on the analysis of the requirement’s purpose, but it also involves a consideration of the negotiations of the parties along with all other circumstances relevant to the formation of the contract or to the requirement itself.”

4. If the condition was not material, was the forfeiture of indemnification a disproportionate forfeiture?

Relying again on the Restatement, the Court held that an immaterial condition should be excused if (1) “the extent of the forfeiture” of the buyer’s indemnification claims outweighs (2) “the importance to the [sellers] of the risk from which [they] sought to be protected and the degree to which that protection will be lost if the nonoccurrence of the condition is excused to the extent required to prevent forfeiture.” The Court instructed the Chancery Court to engage in the weighing analysis on remand but did not offer detailed guidance. Specific to this case, the Chancery Court will have to perform fact-finding to determine whether the buyer’s forfeiture of indemnification for claims up to $7.75 million outweighs the importance to the sellers of avoiding the risk of excess damages, negating the parties’ ability to negotiate with third-party payors, and potentially extending the period of non-compliance and related damages.

Key Takeaways

• Although the case arose from an indemnification claim notice, the Court’s reasoning can apply equally to any M&A agreement condition, including closing conditions, earnout milestones, purchase price adjustments, covenant compliance, and notice obligations.

• While the Court’s purposes in adopting the framework are understandable, the framework itself is likely to inject uncertainty into M&A agreements. Parties should pay more attention to how they draft conditions precedent and evaluate when noncompliance or partial compliance could be excused under the Court’s framework.

• Drafting Considerations: A court is more likely to excuse performance when failure of the condition would result in a significant forfeiture to the other party. Parties desiring to ensure that only full compliance will satisfy a condition should draft the agreement to emphasize the importance of the condition even in light of a potentially significant forfeiture. For example, the parties could:

• State that noncompliance with the condition will result in the forfeiture of contractual rights. For example, sellers should push for language that states noncompliance with indemnification claim notice requirements will result in the loss of the buyer’s right to bring an indemnification claim.
• Specify that the condition and each of its requirements is material to the agreement and may be satisfied only by compliance with each requirement.
• The party likely subject to forfeiture for failure of the condition should acknowledge the importance of the condition to the counterparty and waive any right to assert claims based on disproportionate forfeiture. 
• Include a “time is of the essence” clause specific to the condition.
• Buyers should closely review notice provisions and conditions precedent to ensure they can reasonably be met. In the indemnification context, assess whether the requirements are reasonable. For example, having to provide “all material written evidence” of a claim may not be practical (or necessary) for the initial notice required to be provided within 30 days.

• Disputes involving the satisfaction of conditions in M&A agreements will likely require a well-developed factual record and will become more difficult to resolve in a motion to dismiss. 

• Ultimately, any insight provided by the Chancery Court on remand will be valuable in understanding the evaluation of materiality, disproportionate forfeiture, the interaction with the “material prejudice” requirement, and optimal ways to draft conditions precedent in light of such concepts.