What’s Cooking When It Comes to Enforcing Business Conduct Clauses in Earnouts: Shareholder Representative Services LLC v. Albertsons Cos.

In Shareholder Representative Services LLC v. Albertsons Cos., the Delaware Court of Chancery denied a motion to dismiss claims that a buyer intentionally avoided an earnout payment by misleading the seller about its plans to operate the acquired business after closing.  The case provides additional guidance in the ever-growing body of case-law addressing “business conduct” clauses in earnout agreements.

The dispute arose from a merger agreement (the “Agreement”) pursuant to which Albertsons Companies acquired the internet meal-kit provider, Plated.  Under the terms of the Agreement, Albertsons’ paid the former stockholders of Plated cash consideration of US$175 million, in addition to US$125 million in earnout consideration if Plated achieved certain performance milestones for the three-year period after the transaction.

The Agreement prohibited Albertsons from taking any action with the intent to decrease or avoid an earnout, but it otherwise provided Albertsons with broad discretion in how it operated the business:

[Albertsons] will have the exclusive right to make all business and operational decisions regarding [Albertsons] and its Subsidiaries (including [Plated]) in its sole and absolute discretion without regard to any other interest and will have no obligation to operate [Plated] in a manner to maximize achievement of the Earnout Issuance; provided, however, that [Albertsons] will not, and will cause its Affiliates not to, take any action (or omit to take any actions) with the intent of decreasing or avoiding any Earnout Issuance.

Plated did not hit any of the earnout milestones (which were based on forecasted e-commerce growth rather than in-store sales), and its former shareholders filed suit alleging that Albertsons breached the Agreement by executing on a “hidden agenda” to divert resources away from the company’s e-commerce platform to a more traditional in-store presence.

To support its claims, plaintiffs alleged that Albertsons represented that it would allow Plated to operate independently post-acquisition and would support Plated’s efforts to increase meal-kit market share while gradually phasing in brick-and-mortar initiatives.  According to plaintiffs, Albertsons told plaintiffs that with Albertsons’ support, including economies-of-scale and lower transportation costs, Plated “could easily achieve its projections for the next three years.”

The principal theme of plaintiffs’ case was that these representations were intended to deceive Plated.  They alleged that Albertsons’ management “never really cared about Plated’s e-commerce business” and only acquired the company for the benefit of its existing retail operations. They further alleged that Albertsons had always intended to de-emphasize e-commerce, and that it knew this would cause the company to miss its earnout thresholds.  For example, plaintiffs alleged that immediately after closing, Albertsons diverted substantial resources in a push to get Plated in 1,000 stores within one week. Plaintiffs also alleged that Albertsons interfered with employment decisions and generally mismanaged the company, including by failing to take advantage of preferred pricing  and financing opportunities.

The court held that plaintiffs’ allegations were sufficient to support a reasonable inference that Albertsons breached the earnout agreement (the “Earnout Agreement”).  It reasoned that the plaintiffs’ well-pled allegations suggested that Albertsons knew that pivoting the business model would cause Plated to miss earnout milestones, and that Albertsons’ actions were motivated at least in part by a desire to avoid the earnout. The court noted that it would not be sufficient for plaintiffs to merely allege that Albertsons intended to prioritize brick-and-mortar initiatives over e-commerce.  In this case, however, the court noted that plaintiffs did more, by alleging knowledge coupled with Albertsons’ “scheme” to conceal its true intentions.

Two prior case-law decisions featured prominently in the court’s analysis.  The first was a decision Albertsons relied on out of the District of Delaware: Sharma v. TriZetto Corp. In Sharma, the earnout provision prohibited the buyer from taking any actions in “bad faith” that would have the purpose of avoiding or reducing the earn-out payment.  The  plaintiffs similarly alleged that the buyer breached this obligation by failing to market the business after the acquisition, failing to invest resources in operating the business, and by shifting responsibility to its own sales team that was less familiar with the product. The Sharma court dismissed the claims, holding that plaintiffs’ allegations were insufficient to establish that the buyer “made business decisions with the goal of avoiding the earn-out payment” or that buyer’s “acts [were] inconsistent with routine business practice.” In Albertsons, the court distinguished Sharma on the ground that it did not involve allegations that the buyer knew the changes it was implementing would result in the company missing the earnout targets.

The court determined that a more analogous case was Windy City v. Teacher Insurance.  There, the earnout agreement prohibited buyer from taking action with the intent to avoid an earnout, and it also stated that there would be adjustments to earnout thresholds if the buyer divested acquired assets — but only if that divestiture was to unaffiliated third parties. The plaintiffs alleged that the buyer structured transactions to avoid any corresponding adjustments, and did so with intent to avoid an earnout payment. The court held that these allegations satisfied the “low standard of reasonable conceivability,” and declined to dismiss the claims.

Albertsons and Windy City show that contractual discretion may not be enough to fully insulate buyers from claims that a business decision was made with the intent, at least in part, to defeat an earnout.  Indeed, in Albertsons, the buyer’s contractual protections were particularly robust — the “exclusive right to make all business and operational decisions . . . in its sole and absolute discretion.”  Again, it is notable that this decision only involved the pleading stage, and the evidence may establish that Albertsons did comply with its obligations.

Although the court declined to dismiss plaintiffs’ breach of contract claims, it did dismiss claims for breach of the covenant of good faith and fair dealing and fraudulent inducement.  In both instances, the court relied on the exceedingly broad operational discretion that Albertsons bargained for, reasoning that “[i]f Plated wanted contractual commitments from Albertsons that it would operate Plated in a particular manner post-closing, Plated could and should have bargained for those commitments as carve-outs to the broad discretion it otherwise agreed to give Albertsons.”

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