Delaware Law Alert: New Perspectives on Earnouts

The Delaware Supreme Court has clarified important aspects of Delaware law in the context of an earnout dispute that the Delaware Chancery Court decided in favor of the sellers in 2024. We analyzed the Chancery Court’s decision in a prior Legal Update. In Johnson & Johnson v. Fortis Advisors LLC,¹ the Delaware Supreme Court affirmed most of the Chancery Court’s rulings, but reversed in part, providing important guidance on (1) the interpretation of commercially reasonable efforts standards in the context of a buyer’s post-closing diligence obligations, (2) the circumstances in which Delaware courts may use the implied covenant of good faith and fair dealing in assessing a buyer’s performance of such post-closing obligations, and (3) the application of Delaware’s standard for common law fraud in the context of extra-contractual claims and what is required to avoid liability for such claims. In this Legal Update, we consider lessons M&A practitioners should take into account when negotiating and drafting earnout provisions, especially in life sciences transactions.

Background

The Agreement: In this case, a global healthcare company acquired a robotic-assisted surgical device (RASD) startup. Approximately 40% of the maximum purchase price was in the form of an earnout tied to the achievement of ten separate milestones, eight of which required clearance by the U.S. Food and Drug Administration (FDA) of the target’s RASDs for specific surgical procedures before certain dates and via the FDA’s 510(k) approval pathway. The merger agreement required the buyer to use Commercially Reasonable Efforts to achieve the milestones. “Commercially Reasonable Efforts” was carefully defined using an inward-facing standard (i.e., based on the buyer’s usual practice) and incorporating ten different factors, such as safety issues, competitiveness and patent posture, that the buyer was permitted to consider in determining how to appropriately discharge its efforts-based obligations in relation to the earnout.

Post-Closing Actions: After closing, the buyer began pursing a development strategy that differed from the sellers’ expectations and that sellers asserted was not consistent with the buyer’s obligations under the merger agreement. To complicate matters further, the FDA informed the buyer that the 510(k) clearance pathway was no longer available for the acquired RASDs. Because 510(k) clearance was expressly contemplated by each of the regulatory milestones, the buyer took the position that its obligations in respect of all of the regulatory milestones were effectively negated.

The representative of the selling stockholders sued the buyer for breach of contract, claiming that the buyer had not met its obligation to use Commercially Reasonable Efforts in developing the acquired RASDs to achieve the milestones, and for fraud. The fraud claim was based on statements made by the buyer’s CEO prior to the parties’ entry into the merger agreement to the effect that the achievement of the initial regulatory milestone was a near certainty, notwithstanding information to the contrary that was known to the buyer. The Delaware Chancery Court ruled in favor of the sellers on both claims, awarding them over $1 billion in damages based on the estimated likelihood the milestones would have been achieved had the buyer not breached. The Delaware Supreme Court reversed the Chancery Court’s award of damages with respect to the first milestone, finding that its application of the implied covenant of good faith and fair dealing was not appropriate, but otherwise affirmed the lower court’s rulings.

Below we consider lessons for M&A practitioners from the Supreme Court’s opinion.

Lessons for M&A Practitioners

1. Interpreting Commercially Reasonable Efforts: The Court affirmed and expanded on the Chancery Court’s interpretation of the merger agreement’s Commercially Reasonable Efforts standard and its ruling that the buyer had failed to meet that standard of performance. The opinion provides important guidance for practitioners when drafting efforts obligations and defined terms in the context of earnouts. The buyer’s obligation to pursue the milestones consisted of two components:

• Inward-Facing Commercially Reasonable Efforts Standard: On one hand, the buyer was required to use Commercially Reasonable Efforts to achieve each of the milestones. The requirements involved in using “Commercially Reasonable Efforts” were spelled out in a lengthy defined term. The Court characterized the standard as “inward-facing” because the agreement required the buyer to apply efforts “consistent with the usual practice of [the buyer] with respect to priority medical device products of similar commercial potential at a similar stage in product lifestyle.” The Chancery Court had identified the buyer’s preexisting RASD as the only comparable device, and therefore used its development process to benchmark the buyer’s efforts with respect to the development of priority medical devices.

  Notably, the obligation was framed in relation to the efforts the buyer was to use in achieving the milestones, rather than, for example, in generally developing the acquired RASDs.

  In addition, the agreement prohibited the buyer from acting “with the intention of avoiding” any earnout payment or factoring in the cost of an earnout payment into business decisions after closing.

• Permitted Considerations: On the other hand, the definition of Commercially Reasonable Efforts listed ten factors that the buyer could “take into account” in setting its level of efforts for a priority medical device. These included considerations such as the device’s efficacy and safety, inherent development risks, market competitiveness, patent position, regulatory approval difficulties, legal proceedings, risk of recall, regulatory input, expected profitability, and return on investment.

Legal Analysis: The buyer argued that the qualifier’s ten factors granted it discretion to define commercially reasonable efforts in the context of various general business considerations. From that perspective, these factors would have granted the buyer the flexibility to deprioritize the milestones and apply other strategies to develop the new devices when overall business considerations warranted.

The Court rejected the buyer’s position, agreeing with the Chancery Court’s interpretation that the contract required the buyer to use commercially reasonable efforts to achieve each of the milestones following the buyer’s usual practice with respect to priority medical devices. Thus, the application of the ten factors was “cabined”—the buyer was only permitted to consider the factors “in calibrating the level of effort within those bounds.” In other words, the ten factors allowed the buyer to choose among reasonable paths to achieve the milestones, but they did not permit the buyer to undermine the milestones in the interest of other business priorities.

Elaborating on the Chancery Court’s analysis, the Court applied the interpretive canon against surplusage: giving precedence to the ten factors would effectively swallow the “priority medical device” language and the requirements to pursue the milestones. In addition, the Court concluded that the buyer’s approach would nullify the prohibitions against taking actions to avoid any earnout payment and making decisions based on the cost of earnout payments.

Takeaways: It is not uncommon for earnouts, particularly in life sciences deals, to include qualifiers regarding factors buyers are permitted to consider when calibrating the efforts they are contractually required to undertake. This opinion provides helpful insight into how Delaware courts will interpret such formulations. Importantly, parties must consider these efforts obligations and their qualifiers holistically—if the intent is that the buyer be able to take into account factors extrinsic to the subject of the earnout, it should ensure the drafting makes that clear and that the considerations are not cabined in the context of an obligation to use efforts to achieve the milestones or other earnout objectives.

2. Implied Covenant of Good Faith and Fair Dealing: In rejecting the Chancery Court’s application of Delaware law’s implied covenant of good faith and fair dealing in this case, the Delaware Supreme Court provided guidance on when the implied covenant can and cannot be used when underlying circumstances change in ways the parties might not have accounted for in the agreement and that adversely affect one of the parties.

As noted above, the merger agreement’s milestones required the acquired RASDs to receive FDA clearance specifically via the 510(k) pathway. Although the parties knew the FDA would determine which of several clearance pathways would apply to the RASDs, they drafted the milestones to specifically contemplate 510(k) clearance and did not provide for any alternative pathways. Clearance under 510(k) is generally the fastest and least burdensome approach for devices of this kind. It requires a showing that the procedure it would perform was similar to that of a comparable device (referred to as a predicate device) that had already been approved.

After the merger closed, the parties pursued the first milestone, which required iPlatform to receive 510(k) clearance for a specific surgical procedure. The FDA informed the parties that, iPlatform, the RASD that was the subject of the first regulatory milestone, would no longer be eligible for the 510(k) pathway. Instead, clearance would require the slower, more burdensome De Novo pathway. Contractually, this meant that the first milestone could not be achieved. However, once De Novo clearance for the device was obtained for the initial procedure, iPlatform could become its own predicate device and serve as a basis for 510(k) approval for additional procedures, opening the possibility that the other milestones could still be achieved. Thus, the 510(k) pathway was not foreclosed for the subsequent regulatory milestones.

Legal Analysis: In its opinion, the Chancery Court determined that the change in FDA policy was not foreseeable by the parties and held that, under the implied covenant of good faith and fair dealing, the milestones should be understood to require either 510(k) or De Novo clearance. Accordingly, it concluded that, despite the FDA’s policy change, all of the milestones were capable of being achieved.

The Delaware Supreme Court reversed, holding that the implied covenant could not be applied to alter the plain terms of the agreement. More specifically, the Court concluded:

• There was no gap for the implied covenant to fill in the terms of the agreement, which plainly stated that only 510(k) clearance would satisfy the regulatory milestones. Moreover, the Court noted that in other provisions the parties added flexibility to account for potential regulatory shifts, showing that the parties knew how to address potential changes, yet for the milestones, they committed only to 510(k) clearance.
• The parties were on notice that the 510(k) pathway might not be available. As sophisticated parties, they knew the FDA had authority to require a different pathway, and in fact, months before signing the merger agreement, the FDA had informed the parties that the 510(k) pathway might not be available for the device and that the device differed from other devices that received 510(k) clearance.

Since the first milestone could not be achieved through the 510(k) pathway, the Court held that damages could not be awarded based on the failure to achieve that milestone. However, the Court upheld the damages awarded for the remaining milestones, holding that 510(k) clearance could have been obtained and that the buyer remained obligated, but failed, to use Commercially Reasonable Efforts to pursue 510(k) clearance for the remaining milestones (i.e., by seeking De Novo approval for the device in the first application).

Takeaways: Although the implied covenant of good faith and fair dealing is not something parties typically take into account at the negotiation and drafting stage, this opinion is a reminder that they should assess the range of contingencies that could impact their bargain. The Court made clear that the implied covenant is to be used sparingly and only when (i) there exists a “genuine contractual gap” about a “truly unanticipated development” and (ii) use of the implied covenant is required to “vindicate the parties’ shared expectations at signing.” Thus, as difficult as it may be, particularly in the context of a lengthy earnout period, parties should take care to anticipate and provide for potential changes and build in flexibility to attempt to deal with the unforeseen.

3. Anti-Reliance Provisions for the Benefit of Buyers: Although cases of fraud, in the context of M&A transactions, typically involve claims made by the buyer against the seller, this opinion is a reminder that buyers can be the target of fraud claims by the seller and can benefit from the protection of an anti-reliance provision.

In this case, the stockholder representative claimed that the buyer committed fraud when its CEO gave verbal assurances that a particular earnout milestone had a “high certainty” of achievement and was an “effective up front payment.” Achievement of the milestone depended on using one of the buyer’s own products that the CEO knew at the time was subject to an FDA for-cause on-site inspection for potential violations of FDA rules after a patient death, a situation that was expected to delay the development of the acquired RASD and thus achievement of the milestone at issue. The CEO failed to disclose this information to the target company. The Chancery Court found the buyer liable for fraud and awarded expectation damages based on the target company’s reasonable expectation at the time of the buyer’s statements that the milestone would be achieved.

Legal Analysis: Fraud claims can be based either on representations and warranties expressly included in the agreement or on “extra-contractual” representations as to matters outside the scope of the representations made in the contract, such as oral assurances that might be made during negotiations or due diligence. Although the parties to an agreement cannot eliminate claims based on intentional fraud for representations in the agreement, they can agree that extra-contractual representations cannot provide the basis for a fraud claim. In what is typically called an anti-reliance or non-reliance provision, one or both parties represents that, in entering into the transaction, it relied only on the express representations and warranties that its counterparty made in the agreement and disclaims reliance on any other representations and warranties by any person. Delaware courts will enforce such anti-reliance provisions to preclude claims based on extra-contractual representations. However, courts have held that a standard integration clause or other forms of ambiguous anti-reliance language is insufficient to bar such claims.

In this case, if the merger agreement had included an anti-reliance provision for the benefit of the buyer, the fraud claim would have been blocked because the target company’s stockholders would have disclaimed reliance on the CEO’s extra-contractual statements. The buyer argued that the exclusive remedy provision blocked fraud claims (it included a carveout expressly permitting fraud claims but only those “with respect to making the representations and warranties in this agreement”), but the Court held that such a provision did not constitute sufficiently clear anti-reliance language in the context of the asserted fraud. It also held that when an agreement includes a clear anti-reliance provision disclaiming reliance by only one party, and the other party makes no comparable promise, then an exclusive remedy provision cannot be invoked to bar the other party’s claims for intentional extra-contractual fraud.

Takeaways: While sellers are the typical beneficiary of an anti-reliance provision, buyers should consider including one for their own benefit, especially when the transaction is structured to give the seller a continuing interest in the performance of the business being sold, such as through an earnout, rollover, or issuance of buyer equity. Such an anti-reliance provision should be unambiguous—it would not be advisable for a buyer to attempt to rely on an integration clause or exclusive remedy provision to infer anti-reliance.

¹ ___ A.3d ___, No. 490, 2024 (Del. January 12, 2026).