Earnout arrangements typically involve post-closing obligations on the part of the buyer, who now owns and likely operates the purchased business or assets. This post, the third in our earnout series, takes a look at how the Supreme Court of Canada's November 2014 decision in Bhasin v Hrynew, — a case concerning the role of honesty and good faith in the common law of contract – might affect earnout provisions in future.
Bhasin: Good faith and honest performance in contract law
In Bhasin, the Supreme Court of Canada held that good faith is an "organizing principle" within Canada's common law of contract. What that means, basically, is that good faith is not in itself a general rule of contract law, but rather a principle that underlies and informs a range of narrower common law doctrines that have traditionally required the exercise of good faith in certain limited types of contractual performance. Examples include the good faith obligations that arise in certain relationships, such as "insurer-insured", as well as those that have been held to apply in certain situations, as in the case (for example) of a contract whose central purpose would be frustrated if one side did not endeavour in good faith to obtain a required permit.
One of the key holdings of Bhasin, however, is that, from time to time, the organizing principle of good faith may generate new good faith duties in addition to those that are already recognized. While the court repeatedly emphasized that any new good faith duties would have to evolve by means of gradual and incremental steps, the fact remains that its decision in Bhasin indicates that the range of good faith obligations in Canada can be expected to expand over time.
That gradual expansion began in Bhasin itself, with the court's decision to take the "incremental step" of introducing a duty of "honest performance" into Canadian common law. The duty of honest performance requires that parties not lie or otherwise knowingly mislead their counterparties about matters directly related to the performance of a contract. It creates what the court called a "minimum standard of honesty" – "minimum" because it does not rise to the level of a duty of loyalty or a duty of disclosure. However, while it may not be as onerous as a fiduciary duty, the new duty of honesty, as far as it goes, will be difficult to avoid. There appears to be no way to contract out of it, although the court did state that it can be limited by express contractual language – a point addressed in greater detail in our earlier general discussion of the Bhasin case.
Bhasin and earnouts: short-term effects
One immediate effect of Bhasin is that an argument that a typical1 earnout arrangement has been breached as the result of a lack of good faith can potentially be founded on one or both of the following doctrines of Canadian common law:
- One of the "good faith" duties that, even before Bhasin, was recognized in certain limited situations. A typical earnout may be found to fall within one or more of the generic situations in which a good faith duty of performance has traditionally been recognized, e.g. the situation (mentioned above) in which one party has been left with the discretion to decide how best to achieve an essential element of the contract and must therefore exercise that discretion in good faith. A typical earnout arrangement will often arguably involve exercises of discretion by one party, particularly with respect to the buyer's decisions about how that business should be operated during the earnout period. As a result, a buyer may have to exercise that discretion in good faith. This does not represent a change in the law, of course, as these more narrowly focused "good faith" duties existed prior to Bhasin. For clarity, we should also note that a typical earnout would not likely fall into any of the categories of relationship that typically attract good faith duties, e.g. employer-employee, franchisor-franchisee or insurer-insured relationship.
- The duty of honest performance created in Bhasin. Post-Bhasin, the common law duty of honest performance would apply to the performance of an earnout, as it generally would to all provisions of any commercial contract. A buyer that is operating a purchased business post-closing should accordingly refrain from misleading or lying to a seller about the actions it is taking or intends to take in respect of the earnout.
Bhasin and earnouts: long term2 effects
The Supreme Court of Canada states in Bhasin that, over time, new manifestations of the organizing principle of good faith may be recognized by Canadian common law courts. While any such growth will be gradual and incremental, it is certainly possible that earnouts will be affected by it over the long term. At this point, no one can know precisely which additional good faith obligations will evolve in Canadian common law (or when) but in the specific context that we are considering here, it may be helpful to look briefly at how the doctrine of good faith has been applied to U.S. earnouts. There are two reasons that U.S. jurisprudence is of interest:
- There is currently no Canadian case law that deals with good faith obligations in the context of an earnout; and
- The Supreme Court of Canada recognized in Bhasin that there is a need (and indeed a reasonable expectation) that Canadian common law in this area will become more consistent with the law of U.S. jurisdictions and Quebec, which are common law Canada's leading trading partners. In those jurisdictions, good faith obligations have generally been more liberally applied than has hitherto been the case in the common law provinces of Canada. 3
While we cannot deal in any great depth with the U.S. experience here, it should suffice to note that the following situations – in which U.S. courts have applied good faith duties to the performance of earnouts – may be harbingers of how courts in Canada might deal with similar issues in the coming years:
- A buyer reorganizing the purchased business in a way that diverts sales and strips resources from the purchased business. 4
- A buyer entering into a joint venture with a competitor of the purchased business.5
- A buyer substituting its own products for those of the purchased business 6 or refusing to accept new opportunities generated by the purchased business. 7
- A buyer reducing output of one of the purchased business' more profitable products to prioritize sales of the buyer's incumbent products and changing the name and branding of the products of the purchased business. 8
Moving forward: some general principles
To sum up, general principles that are associated with a duty of good faith (as extracted from Bhasin, other Canadian good faith case law and, to an extent, from U.S. sources) and which may prove to be applicable to the performance of a typical earnout arrangement include the following:
- A party must:
- act honestly;
- exercise its discretion reasonably and for the intended purpose;
- refrain from acting strategically to evade its contractual obligations; and
- not act arbitrarily, unreasonably or in a manner that eviscerates the main objective of the contract.
- In assessing whether a party breached any of its good faith
obligations, consideration will generally be given to:
- the reasonable and legitimate expectations of the parties;
- the express terms in the contract; and
- the particular facts and context of the individual case.
- In addition, where a form of conduct occurs in the context of an earnout that is arguably unjust or unfair, but which does not fall under any existing good faith doctrine, it should be borne in mind that Bhasin could potentially ground the recognition by the court of a new good faith duty to refrain from such conduct.
Conclusion: further thoughts
In the negotiation of an earnout provision, buyers typically seek to expressly limit good faith obligations, most notably including obligations to take action to maximize the earnout. While the duty of honesty established in Bhasin v. Hrynew appears primarily to target lying and deliberate deception, the fact that this new duty cannot be entirely disclaimed may need to be considered in the drafting of some earnouts. As well, buyers would likely bargain to broaden the scope of, and discretion in, their operational decisions relating to the purchased businesses, which could engage good faith duties arising out of the established category of discretionary contracts. Sellers – whose negotiating focus is typically on imposing specific obligations, actions and limitations that apply to the operation of the business post-closing – are not as likely to be affected by these types of obligations post-closing. However, to balance the concerns of each party, in addition to careful drafting, a little "good faith" may be required.
1 In the majority of cases, an earnout is structured so that the buyer will operate, or at least control and oversee the operation of the purchased business post-closing. It is this scenario that is referred to as a "typical" earnout arrangement.
2 Until we see how enthusiastic Canadian courts turn out to be with respect to the recognition of new good faith duties, it will be difficult to know how long the "long term" is likely to be.
3 The Bhasin decision also specifically refers to the good faith requirement in §1-302(b) of the Uniform Commercial Code, which has been adopted in almost all U.S. jurisdictions.
4 Interwave Technology, Inc v Rockwell Automation, Inc 2005 U.S. Dist. LEXIS 37980 (E.D.Penn.); Kuchera v Parexel International Corporation, 719 F. Supp. 2d 121 (D. Mass. 2010); TWA Resources v Complete Production Services, 2013 Del. Super. LEXIS 319.
5 LaPoint v AmerisourceBergen Corporation, 2007 Del. Ch. LEXIS 131 (Del. Ch.), aff'd 956 A.2d 642 (Del. 2008).
6 Jaqueline T. Hodges & HRC Solutions, Inc. v. Reasonover, 2008 US Dist LEXIS 12254 (N.D. Ga.).
7TR McClure & Co v TMG Acquisition Co, 1999 U.S. Dist. LEXIS 13676 (E.D. Penn.); in Sonoran Scanners, Inc v PerkinElmer, Inc, 585 F.3d 535 (1st Cir. 2009), a duty of good faith was breached when the buyer refused to use reasonable efforts to generate new business opportunities as stipulated in the earnout contract.
8 Horizon Holdings, LLC v Genmar Holdings, Inc, 387 F.3d 1188 (10th Cir. 2004). See also other U.S. cases, such as: Airborne Health, Inc v Squid Soap, LP, 984 A.2d 126 (2009 Del. Ch.); Winshall v Viacom International, Inc, 55 A.3d 629, (Del. Ch. 2011); Ferguson v Lion Holding, Inc, 478 F. Supp. 2d 455 (S.D.N.Y. 2007); Agilysis, Inc v Gordon, 2008 US Dist LEXIS 99553 (N.D.OH.); Rubin Squared Inc v Cambrex Corp, 2007 U.S. Dist. LEXIS 62861 (S.D.N.Y.), aff'd 2009 U.S. App. LEXIS 6244 (2d Cir. N.Y., Mar. 25, 2009); Rumis v Brady Worldwide Inc>, 2007 U.S. Dist. LEXIS 37190 (S.D. Cal.); Starr v Firstmark Corp, 2013 U.S. Dist. LEXIS 128361 (E.D.N.Y.); Keene Corporation v. Bogan, 1990 U.S. Dist. LEXIS 220 (S.D.N.Y.); Wagner v. JP Morgan Chase Bank, 2011 U.S. Dist. LEXIS 24518 (S.D.N.Y.);Fireman v. News America Marketing In-Store, Inc, 2009 U.S. Dist. LEXIS 91236 (D. Mass.).
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