Earnouts, AI, and Equitable Remedies: Delaware Court Reinstates CEO and Extends Payout Clock

Earnout remedies are not limited to damages.  In Fortis Advisors v. Krafton, the Delaware Court of Chancery awarded specific performance to reinstate a target company’s CEO and extend the earnout by the time that elapsed between the CEO’s wrongful, ChatGPT-informed termination and his restoration.  The decision also highlights a growing business risk: executives’ direct use of AI tools may not be privileged if it does not involve legal advice from counsel, and AI prompts may become discoverable evidence.

Earnout Bargain and the Buyer’s CEO’s AI-Crafted Plan To Avoid It

To win a competitive process to acquire the video game studio Unknown Worlds Entertainment (“Target”), Krafton, Inc. (“Buyer”) agreed to pay $500 million in cash upfront and up to $250 million as an earnout.  The earnout was unusual in that the two founders and the current CEO (collectively, the “Key Employees”) would retain operational control of the business in all material respects after the closing.

As the Target neared the release of a hotly anticipated video game, the Buyer became concerned that the revenue from the game release would trigger the earnout.  The Buyer’s analysis showed the enterprise value for the Target of approximately $93.5 million compared to a projected $191.8 million earnout.  The Buyer became concerned that the earnout would result in the Buyer overpaying for Target.  Seeking to avoid paying the earnout, the Buyer’s CEO turned to ChatGPT to develop a strategy if the Buyer failed to reach a deal with the Target; ChatGPT responded that the earnout would be “difficult to cancel” but nevertheless provided a strategy to do so as requested.  Executing the strategy, the Buyer terminated the Key Employees and took control of the Target.  However, the purchase agreement only permitted the Key Employees to be terminated for “Cause.”

For “Cause” Terminations

The purchase agreement had a multiple-pronged definition of “Cause,” but the only prong at issue was whether the Key Employees engaged in an “intentional act of … dishonesty.”  The interpretative dispute turned on the word “intentional.”  The Buyer argued that “intentional” required a deliberate act, regardless of the actor’s subjective purpose.  The Key Employees argued that “intentional,” as part of the phrase “intentional act of dishonesty,” required an intent to deceive.  The court agreed with the Key Employees, which meant that the Buyer had to show a conscious objective to deceive.

The Buyer advanced two rationales for the terminations.  First, the founders reduced their involvement in the Target, and the Buyer argued the Key Employees kept the Buyer in the dark about it.  While the court found that the founders’ roles changed, the court also found that the Key Employees were transparent with the Buyer about these changes.  Second, the Key Employees downloaded the Target’s confidential information before they were terminated.  While these data downloads were wrongful, the court found that the Key Employees did so to protect the Target and returned the confidential information when requested by the Buyer.  Although the downloads were “intentional,” the court found that they were driven by a good faith, defensive motive.  Consequently, the court concluded that the Buyer did not have the right to terminate the Key Employees for Cause.

Right to Operational Control

Because the Key Employees were not terminated for Cause, they retained the right to control the Target unless the Buyer had other grounds to strip them of control.  The purchase agreement required the Key Employees to operate “in the ordinary course of business,” defined as the “usual and ordinary course of such Person’s business consistent with past custom and practice.”  The Buyer argued that the Target was not operating in accordance with the “past custom and practice” because the founders stepped back from day-to-day operations after the closing and even changed their titles.  The court disagreed and found that the ordinary course covenant was not breached because an ordinary course covenant is assessed at the company level, not the employee level.  The Target continued operating as it always had—a flat, remote organization with the founders delegating primary development duties to other employees—and the new video game was on track for launch.  Moreover, the purchase agreement did not have a covenant to require the founders to continue to work for the Target after the closing.

Remedy  

The Key Employees sought specific performance.  Normally, they would have had to make a “clear and convincing showing” of their entitlement to specific performance.  However, the purchase agreement, as is typical, included specific performance as a remedy.  This is an important provision to include because, although specific performance is a matter of equitable discretion, Delaware courts will enforce the specific performance bargain unless the breaching party presents a persuasive reason not to.  In this case, the court found that equity favored a tailored solution.  First, the court reinstated the CEO, who could hire the founders as consultants and release the new video game when he deems appropriate.  Interestingly, the CEO and founders were not reinstated to the board.  The court found that the Buyer, as the sole stockholder, was entitled to elect the directors.  However, the board was enjoined from interfering with the CEO’s bargained-for operational control set forth in the purchase agreement.

Second, the earnout’s testing period was extended by the number of days the CEO was ousted.  Even with the equitable extension, the litigation is not over.  The Buyer had also covenanted in the purchase agreement not to “take any actions [with] the primary business purpose of … depriv[ing]” the sellers of the earnout, and the sellers may be entitled to earnout revenues permanently lost due to the Buyer’s breaches.

AI  

A quick side note about the use of AI.  The opinion quoted at length the Buyer’s interactions with ChatGPT, which the Buyer used to seek guidance on how to avoid the earnout and how to take control of the Target.  Because this advice was not generated through legal counsel, it was not privileged, which allowed the advice to become evidence in the case.

Takeaway

Buyers are on notice that if they deprive seller-managers of bargained-for control during the earnout period, Delaware courts may do more than award damages later.  Courts can restore control and extend the earnout period so that the sellers have a fair shot at hitting the earnout, consistent with the parties’ bargain.  Deal parties should therefore treat post-closing governance provisions as integral to earnout economics, not merely ancillary protections, and remember that deal parties will have to live with these governance provisions for the duration of the earnout period (or possibly longer in the case of litigation with an equitable remedy).

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.