In the recent decision of Himawan v. Cephalon, Inc.C.A. No. 2018-0075-SG (Del. Ch. Dec. 28, 2018), the Delaware Court of Chancery ruled on a motion to dismiss filed in an earnout dispute.  The Plaintiffs are representatives of former stockholders of an entity that was acquired by Cephalon, Inc. through a merger agreement that involved an initial sales price along with earnout payments.  The earnouts were payable upon the meeting of certain milestones in the approval of the antibody to treat two different conditions, in both Europe and the United States. The buyer agreed to use “commercially reasonable efforts” to develop the antibody and achieve the milestones.

Plaintiffs alleged that the buyer’s efforts, which were abandoned with respect to development of the antibody to treat one of the medical conditions upon which earnout payments depended, were not commercially reasonable.  Defendants moved to dismiss, arguing, among other things, that the complaint is defective because the merger agreement leaves discretion on how to pursue development of the antibody with the buyer.

“Commercially reasonable efforts” is defined in the Merger Agreement as “the exercise of such efforts and commitment of such resources by a company with substantially the same resources and expertise as [Cephalon], with due regard to the nature of efforts and cost required for the undertaking at stake.”  The Court found that this language is clear and unambiguous, and set forth an objective standard.  Further, per the merger agreement, the former stockholders of the acquired company “shall have no right object to the manner in which business of the Surviving Corporation is conducted,” and the buyer “shall have complete discretion with respect to all decisions related to the business of the [acquired company].”

In this respect, the Court noted that the “Plaintiffs here face a difficult matter of proof.”  Slip op. at 2.  However, the Court took note of language in the merger agreement requiring “the exercise of such efforts and commitment of such resources by a company with substantially the same resources and expertise as [Cephalon]”.  Slip op. at 17.  The Court found that it was unclear what additional obligations, if any, were imposed upon Cephalon by such language.  Accordingly, the Court declined to grant the motion to Plaintiffs’ breach of contract claims, noting that “[a]t the pleadings stage, however, I must employ plaintiff-friendly inferences, consonant with which I find that the Defendants have only identified factual issues that may be resolved when a record is created.”

However, the Court dismissed Plaintiffs’ claim for breach of the implied covenant of good faith and fair dealing.  The Court found that there were no “gaps” in the merger agreement requiring the involvement of the implied covenant.  Further, the Court dismissed the tortious interference claims against certain other named defendant entities that later acquired Cephalon after the merger.  The Court found that such allegations were conclusory and therefore dismissed the same under Rule 12(b)(6).

Key Takeaway:  This case demonstrates the importance of clarifying what “commercially reasonable efforts” a buyer is required to follow under a merger agreement, as those efforts may have a significant impact on the earnout payments owed to a seller under such merger agreement.

Carl D. Neff is a partner with the law firm of Fox Rothschild LLP.  Carl is admitted in the State of Delaware and regularly practices before the Delaware Court of Chancery, with an emphasis on shareholder disputes. You can reach Carl at (302) 622-4272 or at cneff@foxrothschild.com.