United States: "Commercially Reasonable Efforts" Diligence Obligations In Life Science M&A

More than 80 percent of all deals in the pharmaceutical, medical device and biotech industries include an earnout structure that provides some type of contingent or delayed payment of proceeds to the sellers (2012 SRS Life Sciences M&A Study).  Trends vary widely, but in many transactions, the earnout consideration can far exceed the up-front payment to the sellers.  This earnout consideration is frequently contingent on post-closing achievement of certain clinical study results, product approvals, reimbursement or sales.  As a result, sellers during transaction negotiations intensely focus on the obligations of buyers to use corresponding "diligence" to achieve the goals that will trigger the contingent payment to the seller.  This focus frequently comes to rest on the obligation of a buyer to use "commercially reasonable efforts" and the related definition of this obligation in transaction documentation.  This article reviews the common approaches to defining "commercially reasonable efforts" and analyzes several recent cases interpreting the definitions in deal documentation.

Common Approaches to Defining Commercially Reasonable Efforts

Outward Facing Definition

An outward facing definition of commercially reasonable efforts applies an industry-standard requirement or looks to other participants in the industry to define the diligence obligations of the buyer.  An example of this type of definition is:

"Commercially Reasonable Efforts" means the efforts consistent with the past practice of similarly situated pharmaceutical companies with respect to similarly situated pharmaceutical products.

This definition is generally viewed as more favorable to the seller of a technology, as it enables the seller to point to other industry standards that would have the buyer take additional steps to achieve the goal that would result in a payout on the earnout.

Inward Facing Definition

In contrast, an inward facing definition applies the buyer's own standard for undertaking research, regulatory approvals, and sales and marketing efforts.  An example of an inward facing definition of commercially reasonable efforts is:

"Commercially Reasonable Efforts" means efforts consistent with the past practice of Buyer related to research and development, regulatory approval, commercialization, sales and marketing of similar oncology therapeutic products with similar market potential at a similar stage in its development.

This definition is more favorable to a buyer because it allows the buyer to point to its own investment thresholds and decision processes.  Buyers can typically point to a similar situation where a step or expenditure of funds would not have been taken.

No Definition

An option for buyers and sellers is to leave the term undefined.  In the event of a dispute, a judge or mediator would look to case law and the facts of the situation to determine whether the appropriate level of diligence was utilized.  It should be noted, however, that some states' courts (most notably, Illinois) have interpreted terms such as "best efforts" and "commercially reasonable efforts" to be so vague as to be unenforceable.  (See Kraftco Corp. v. Kolbus, 274 N.E.2d 153, 156 (Ill. App. Ct. 1971).)  For an excellent discussion of courts' varying interpretations of different due diligence standards, including commercially reasonable efforts requirements, see Kenneth A. Adams' article.

Recent Cases

Many transaction documents incorporate mandatory arbitration provisions.  In fact, sophisticated buyers understand that there are frequently dramatic changes post-closing related to medical products and, therefore, include a variety of structures to amicably settle earnout related disputes outside the courtroom.  As a result, most disputes related to diligence obligations are handled out of court, which results in a limited number of cases that directly address the interpretation of commercially reasonable efforts obligations.  Two recent cases, however, have given insight to judges' review of these obligations.

Volcano Corporation/CardioSpectra

In Banas v. Volcano Corp., the former owners of CardioSpectra, Inc. challenged whether Volcano Corporation used appropriate diligence to develop and sell CardioSpectra's medical device system.  Banas v. Volcano Corp., 2014 WL 1309720 (ND Calif. 2014)  The merger agreement required Volcano to use "commercially reasonable efforts" and to "act in good faith" when working to achieve the goals that would result in additional merger consideration payable to the former shareholders of CardioSpectra.  The merger agreement defined commercially reasonable efforts as:

... the use of efforts, sales terms, expertise and resources normally used by [Volcano] for other products, which, as compared with the OCT Products; are of similar market potential at a similar stage in its development or product life, taking into account all reasonable relevant factors affecting the cost, risk and timing of development and the total potential of the applicable OCT Products, all as measured by the facts and circumstances at the time such efforts are due ...

The definition used in the CardioSpectra merger agreement was inward facing and required the sellers to demonstrate that commercially reasonable efforts were not used compared with efforts made for other similarly situated Volcano products.  The court granted summary judgment to Volcano because the sellers failed to present any evidence that demonstrated Volcano's efforts with similarly situated products.  The judge determined that without such evidence, the sellers could not make claim for breach of the merger agreement.

In addition to addressing commercially reasonable efforts, the judge examined whether Volcano failed to act in good faith in development efforts.  The merger agreement did not define act in good faith, so the court looked to case law to determine the standard.  Examining the evidence, the court found that Volcano had expended significant resources, hired sufficient personnel and had not willfully abandoned the development of the CardioSpectra system.  As such, it determined that Volcano had not breached the merger agreement by failing to act in good faith.

Sekisui/America Diagnostica, Inc.

Also in the first quarter of 2014, a judge examined counterclaims in a lawsuit brought by Sekisui America against the former shareholders of America Diagnostica, Inc. (ADI).  Sekisui America Corp. v. Hart, 2014 WL 687222 (S.D. NY 2014).  In counterclaims against Sekisui, the former shareholders of ADI alleged that Sekisui America had breached the stock purchase agreement by failing to use "commercially reasonable efforts" and omitting actions "with the intent of preventing [ADI] from meeting ... revenue targets ..."  The term commercially reasonable efforts was not defined in the stock purchase agreement.

The court found that the sellers had failed to prove a breach of the diligence obligations because they did not present evidence establishing the objective standard for commercially reasonable efforts in the regulatory context of the U.S. Food and Drug Administration, nor did they explain how Sekisui America deviated from that standard.  Further, the court found that there was no evidence demonstrating that Sekisui America intentionally omitted actions to prevent the revenue targets from being met.

Tips and Takeaways

Inward Facing Definitions Add Hurdles for Sellers

As demonstrated by Volcano, an inward facing definition of commercially reasonable efforts adds significant hurdles for the sellers attempting to prove that diligence requirements were breached.

Additional Requirements to Use "Good Faith" Should Be Defined

Sometimes drafters will toss in additional references or requirements to use good faith in the diligence obligation section of an M&A document.  Such terms should be cautiously used because, as seen in both Volcano and Sekisui America, this allows a seller to further attack the buyer's effort.  If good faith is an obligation of the buyer, consider defining the requirement further.

Define the Impact of a New Technology Acquisition

Acquisition documentation frequently fails to address the impact of newly acquired technology.  If it is not specifically addressed in the document, courts will be left to discern the intent of the parties if a new acquisition is made that impacts existing diligence or milestone obligations.  Ideally, a buyer would have a clear statement that the acquisition of a new technology involving the same therapeutic area is permitted.

Business Teams Should Be Aware of Implications of "Shelving" the Acquired Technology

Although not examined in either Volcano or Sekisui America, other litigation and mediation involving diligence obligations have shown that sellers can win large damage awards if the buyer's business team "shelves" or otherwise abandons an acquired technology where the acquisition documentation included a diligence obligation.  It is worth the additional time and effort to avoid protracted litigation to establish strong documentation as to why development, regulatory or sales efforts related to a technology were shelved.

Consider the Impact of Specific Diligence Milestones

In addition to requiring a buyer to use commercially reasonable efforts, sellers will often require a buyer to meet certain specific diligence milestones, regardless of whether buyer is using commercially reasonable efforts.  The diligence milestones are typically key product development or commercialization events, and will often trigger one or more earnout payments.  A buyer's failure to achieve a milestone may result in breach of its obligations to a seller, even in the event that a buyer was otherwise using commercially reasonable efforts to meet such milestone.

Buyers Should Consider the Benefit of Safe Harbor Provisions

In the event that the buyer satisfies a specified milestone in a timely manner, a safe harbor provision can deem a buyer to have used commercially reasonable efforts in achieving such milestone.  This will relieve the buyer of all or part its obligation to use commercially reasonable efforts.  Such milestones may include development achievements, regulatory approvals or financial events such, as net sales achievements.  Preferably, a buyer will want to negotiate optional safe harbor events that, if met, will demonstrate the buyer's use of commercially reasonable efforts without creating mandatory obligations.

Consider Third Party Diligence Obligations

Buyer should be aware that, to the extent that it acquires intellectual property through a sublicense issued by a seller (i.e., seller has in-licensed intellectual property from a third-party licensor), the seller may have its own diligence obligations it owes to its third-party licensor that will need to be satisfied to retain its in-license.  It is also likely that, with respect to the technology sublicensed to the buyer, the seller will rely on the buyer's diligence to satisfy the seller's obligations to its licensor.  Therefore, the seller's hands may be tied when it comes to negotiating a buyer's diligence obligations and remedies.  If such diligence obligations and remedies are unacceptable to the buyer, the only acceptable alternative may be for the seller to renegotiate its diligence obligations with the third-party licensor.

Define Specific Circumstances Under Which Buyer Will Be Excused

Despite good faith intentions, events can occur that make unreasonable the continued use of commercially reasonable efforts.  In addition to force majeure, such events can include failure to obtain regulatory approval as expected, unexpected safety concerns, unexpected market shifts or unfavorable commercial circumstances that adversely affect product viability, and inability to obtain commercially viable reimbursement levels.  It is best to anticipate the possibly of such events and provide reasonable tolling and other remedial provisions.

Consider Disclaimers

If a buyer and seller agree that no specific diligence standard will be required (i.e., the buyer will not be required to use commercially reasonable efforts, or any other level of efforts for that matter), the agreement should include a disclaimer on point.  It is otherwise too easy for a court to imply at least some level of good faith efforts into the agreement that were never intended or agreed to by the parties.

"Commercially Reasonable Efforts" Diligence Obligations in Life Science M&A

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.