Business sellers who want to protect their earn-out entitlements should push to ensure that the buyer has minimal room to change or abandon the business.
Porton Down is the UK Government's top secret chemical and biological warfare research facility.
Strangely, it is also a business operation. One of its commercial offshoots was recently involved in a major court case concerning an earn-out provision in a share sale agreement.
The case highlights the importance of precise drafting in earn-outs.
Trial and error
A Porton Down company developed BacLite, a new test for staphylococcus aureus (aka golden staph). BacLite was intended to overcome financial and operational issues that affected other commercial tests for golden staph.
After successful trials in the UK and sales to a few hospitals, the company was sold to 3M in February 2007.
The purchase price consisted of an upfront payment of £10.4m and an earn-out payment equal to the net sales of the product in calendar year 2009. The earn-out clause obliged 3M to "diligently seek" regulatory approval outside of the EU and to "actively market" BacLite. The sale agreement also required 3M to keep the company in business unless the sellers agreed otherwise (such agreement not to be unreasonably withheld).
FDA approval was needed in order to sell BacLite in the USA.
To that end, 3M began initial US trials in June 2007. By November 2007, it was clear that the US tests were producing quite different (and more disappointing) results from those in the UK.
3M decided to put the trials on hold while the problem was investigated. At the same time, 3M's senior management began to seriously consider pulling the pin on the product in the US. Despite eventually understanding the reasons for the poor results (mostly problems with the design of the clinical studies), no further efforts were made to obtain US approval after June 2008. 3M also wound down its marketing efforts in the EU, and by June 2008 had effectively stopped seeking new customers.
In July and August 2008, 3M was looking to cut its losses. In accordance with the sale agreement, 3M asked the sellers to release it from its ongoing obligations to develop and market BacLite. 3M offered the sellers US$1.1m to settle the matter.
When the sellers refused to accept its offer, 3M decided to act unilaterally. The business was shut down at the end of 2008.
The sellers alleged that 3M had breached the sale agreement in two important respects by not:
- "diligently" seeking regulatory approval; and
- "actively" marketing BacLite.
Without those breaches, argued the sellers, BacLite would have achieved sales of $56.45m (£32m) in calendar year 2009.
Perhaps unsurprisingly, the Court held that, once 3M pulled the plug on BacLite (in July 2008), it had breached the sale agreement. What is interesting, however, is the Court's discussion of whether 3M had breached the agreement before that point.
"Diligently seeking" regulatory approval
As noted above, the first clinical trials in the USA (required for FDA approval) did not go according to plan, differing significantly from the results of the UK trials. There were several reasons for this, including:
- 3M had misunderstood an FDA requirement about the appropriate test against which BacLite was to be compared and, as a result, 3M employed a comparator which was commonly used in the USA (but which was not the same comparator used in the UK trials); and
- rather than conducting the US trials at precisely the same temperature used in the UK trials, 3M (acting on advice from the scientists who had conducted the UK trials) conducted the US trials within a 2 degree temperature range.
By the time these issues had been identified, 3M was already well on the way to abandoning the business. As a result, it was decided not to conduct new trials or seek FDA approval.
The sellers claimed that the issues with the clinical trial and the abandonment constituted a failure to "diligently" seek FDA approval. They argued that "diligently", in this context, meant to act with reasonable care.
The Court agreed with 3M that the obligation to act diligently was not a high standard of perfection or even any specific standard of expertise, but simply a requirement of reasonable application and industry perseverance. The Court considered that diligently seeking regulatory approval required judgments about which people might reasonably differ.
On that basis, the Court held that 3M had acted diligently. Although misunderstanding the FDA requirements, 3M had trialled BacLite by comparing it with a different comparator and had had no reason to believe that this would produce materially different results from the UK trial. In fact, the UK scientists told 3M that no problems were expected from using the different comparator. Additionally, the temperatures at which the US trials had been conducted were on the basis of advice from the UK scientists that the 2 degree temperature range should be acceptable.
The Court added that, if the sellers had intended that 3M should employ reasonable care, that should have been clearly stated and defined in the sale agreement.
3M did not recruit a sales force for BacLite until September 2007 (ie. seven months after acquiring it). It did, nevertheless, engage in various marketing activities before that time.
The sellers argued that the delay in recruiting salespeople was a breach of 3M's obligation to "actively" market BacLite, for two reasons:
- because the earn-out only applied to earnings during calendar year 2009, the obligation to actively market BacLite effectively required 3M to hit the ground running from the moment it acquired the business at the start of 2007; and
- the meaning of "actively market" was reflected in a sale agreement clause that 3M should devote the same level of resources to marketing BacLite as it devoted to its other products.
In response, 3M argued that:
- the requirement to "actively" market simply meant that it had to engage in some marketing, rather than none; and
- its marketing activities before acquiring a salesforce had constituted an "active" marketing effort.
The Court disagreed with 3M on the first point, but agreed with it on the second.
The Court held that "actively" required more than simply taking some steps to go out and sell the product. It certainly required more than simply not being passive. Rather, the marketing efforts viewed overall had to be "characterised by action". The Court recognised that this involves a degree of leeway or a "reasonable margin of appreciation" in terms of the precise action required. So long as 3M acted in good faith with a view to marketing the product successfully in pursuit of the parties' common commercial interest, then that would suffice.
3M had worked hard and put in "considerable and impressive" efforts in marketing up to March 2008. Marketing became more targeted after that point in time, but the Court considered this was still characterised by action.
By June 2008, however, there was no real effort to find new customers (although 3M continued to work on existing customers). 3M was therefore in breach of the sale agreement.
Winning the battle, losing the war
The sellers' victory turned out to be largely symbolic.
Since 3M had stopped marketing the product before calendar year 2009 had even arrived, the Court had to assess the likely level of sales and therefore the amount of the earn-out payment which the sellers should have received.
Looking at all the evidence, it agreed with 3M that BacLite would have been a commercial failure. Apart from the difficulties with the trials, competitor products had been improved to the point where there would have been little market for BacLite.
As a result, the Court concluded that, even if 3M had persisted with the product, sales of no more than US$2.1m would have been likely, giving the plaintiff sellers (who represented about 60% of the original shareholders) an earn-out of US$1.3m (slightly above 3M's original pay-out offer, but well short of the US$33m the sellers were seeking).
This case has important lessons for both sellers and buyers.
As is often the case in contractual disputes, the proof of the pudding is in the drafting. Business sellers who want to protect their earn-out entitlements should push to ensure that the buyer has minimal room to change or abandon the business. Ways in which this might be done include:
- avoiding vague terms such as "diligently" and "actively" when describing the buyer's obligations, insisting instead on objective tests (eg. prescribing how the key aspects of a clinical test or similar exercise should be conducted):
- requiring the buyer to provide access to information and business records during the earn out period, to provide the seller with regular reports, and to notify and consult with the seller in relation to key matters; and
- including a right to buy back the product if the buyer stops supporting it or is not doing a good enough job of developing it.
The message for buyers is more mixed. The case shows that a buyer might be obliged to continue progressing and marketing a product even if the product is a failure. Doing nothing might be a breach of contract, even if that is commercially the most sensible decision. To counter this, a buyer might consider provisions which allow it to stop supporting the business if certain foreseeable events occur (such as, in this case, if trials are unsuccessful or sales are much lower than expected). Buyers could also try to argue for an implied term to this effect.
A pragmatic observer may take the view that, whatever the buyer's legal position, this case shows that the reality is quite different: if the buyer drops the business because it's a commercial dog, any damages award for a broken earn-out clause will be minimal, because the business was never going to be successful anyway.
That pre-emptive approach does suffer from one high-risk fundamental flaw: the court could, with the benefit of hindsight, take a very different view of the future viability of the business.
Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.