Words Matter: Different Definitions of “Commercially Reasonable Efforts” Lead to Different Results in Drug-Development Earnout Disputes

Acquisitions of biotech companies with development-stage drug candidates often include earnout agreements.  The buyer pays the seller’s stockholders with cash or stock upfront, and the seller’s stockholders are entitled to additional payments if the drug or drugs in development reach certain milestones, often culminating in FDA approval or commercialization.  Achieving those milestones can take many years and requires the buyer to make substantial investments in clinical trials and regulatory approval.  Because the right to earnout payments depends to a significant degree on a buyer’s actions in developing the asset, a seller will seek a provision in the acquisition agreement requiring the buyer to use commercially reasonable efforts in drug development.

In the past several months, the Delaware Court of Chancery has issued a number of post-trial rulings related to a buyer’s commercially reasonable efforts (CRE) clauses.  In two such cases—   Shareholder Representative Services. LLC v. Alexion Pharmaceuticals, Inc., and Himawan v. Cephalon, Inc.—companies with a single drug asset were acquired for cash, with an opportunity to earn nearly double the upfront payment—or more—on the achievement of specified milestones.  In both cases, the buyers were themselves later purchased by larger pharmaceutical companies and the ultimate acquirers decided to discontinue drug development. The stockholders of the original sellers sued for breach of the commercially reasonable efforts clause in the merger agreements.

In Alexion, the stockholders prevailed:  The court found that the company had breached the CRE clause.  In Cephalon, the buyer prevailed:  The court found that the company had complied with the CRE clause.

To some extent, the differing outcomes was factual.  In the development work it performed before abandoning the drug, Cephalon encountered serious medical, regulatory, and commercial obstacles.  Cephalon was also able to point to a track record of substantial development activities.  The company obtained FDA and European approval for one of the two indications at issue, after which the drug proved to be a commercial failure.  The dispute in Cephalon was over the company’s abandonment of the drug for the second indication.

In Alexion, by contrast, the parties sharply disputed the significance of a safety concern the company identified in a Phase 1 trial, after which it ceased its development efforts.  The court sided with the plaintiff in that dispute, thereby minimizing the significance of barriers to successful development, approval, and commercial competitiveness.

Alongside these factual differences, and equally important, were differences in the phrasing of the CRE clauses.  The merger agreements in both cases included detailed definitions of “commercially reasonable efforts.”

• In Alexion, the critical language was “such efforts and resources typically used by biopharmaceutical companies similar in size and scope to [Alexion] for the development and commercialization of similar products at similar development stages.” This language was followed by 11 factors to be “tak[en] into account,” related to, among other things, safety, efficacy, likelihood of approval, and commercial viability.
• In Cephalon, the critical language was “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 costs required for the undertaking at stake.”

Both definitions are what is termed “objective,” or “outward-facing.”  The reference point is what other similar companies would do, and not solely what is commercially reasonable for the buyer.  In both cases, the merger agreement also included a “discretion” clause, under which the acquiring company had sole or complete discretion with respect to all business decisions.  And in both cases, the court understood the CRE clause as a limitation on the discretion clause.

A key question in both cases was whether the CRE clause permitted consideration of circumstances unique to the acquiring company.  This is where the courts parted ways—based on differences in the definition of CRE.

Alexion faced two unique circumstances.  Before its acquisition by AstraZeneca, it was in the midst of an initiative to launch 10 new drugs by 2023.  After the acquisition, Alexion and AstraZeneca were committed to merger synergies.  The court ruled that considering these factors in making decisions about drug development was inconsistent with the definition of CRE.  With respect to the first circumstance, the court reasoned:

“10 by 2023” was not a typical factor.  It was an idiosyncratic corporate initiative.  A reduction in drug development efforts to accommodate such a unique program cannot satisfy an outward-facing efforts clause based on the typical efforts of similar companies.

With respect to the second circumstance, the court concluded that the company’s decision to discontinue drug development “was influenced, motivated by, or driven by [the] pursuit of merger synergies”—and that this was impermissible under the definition of CRE.

In Cephalon, the unique circumstances included the earnout provision itself.  In an internal email, a Cephalon/Teva executive wrote that the drug at issue was “scientifically . . . viable” for the indication in question, but “assum[ed] that a potential $200 [million] . . . milestone payment may be the ‘killer.’”  The court held that this was a permissible consideration—notwithstanding the fact that it was unique to the company, and permitted the company to work against the interests of the seller’s stockholders.  The court focused on the phrase “due regard to the nature of efforts and costs required” in the definition of CRE.  That language, the court explained, “includes all the costs and risks involved, including the milestone payments and the opportunity costs faced by [the company].”  In the court’s view, the CRE clause limited Cephalon’s discretion only insofar as it required the company to “go forward in its own self-interest” (emphasis in original).  The court noted that the highly buyer-friendly definition of CRE was “unusual,” and “gives sellers little protection, since it is invoked only to disallow actions of the buyer that would be against the buyer’s self-interest.”  But this did not give the court pause.  The weak CRE clause was “all that the sellers bargained for.”

Cephalon and Alexion together highlight the range of possible meanings of “commercially reasonable efforts.”  The decisions suggest that for both sellers and buyers, language that includes—or excludes—considerations unique to the acquiring company can be critical, particularly as those factors may come into existence years after the acquisition.  The language in Cephalon was so permissive that the company was allowed to actively work against the seller’s interests in determining not to invest in drug development.

Aside from these contract interpretation issues, both decisions are notable for the courts’ very deep dive into the scientific, medical, regulatory, and commercial factors affecting drug development.  In Alexion in particular, the court delved into the drug’s mechanism of action and delved even deeper into possible interpretations of clinical trial data in its 139-page decision.  Unsurprisingly, the court emphasized the value of expert testimony in these areas and was reluctant to assign weight to lay testimony without a foundation of personal knowledge.

This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.