Delaware Supreme Court Makes Earnouts Less Risky for Buyers
Earnout Decision Partially Reversed Because Buyer Did Not Have to Pursue an Alternative Regulatory Pathway

Buyers faced increased financial risk when doing deals with earnouts after the 2024 Delaware Court of Chancery decision in Johnson & Johnson v. Fortis Advisors LLC.  However, the Delaware Supreme Court partially reversed that decision and limited the application of the implied covenant of good faith and fair dealing—this has de-risked earnouts for buyers.

510(k) Pathway

As part of Johnson & Johnson’s (the “Buyer”) acquisition of Auris Health, Inc. (the “Seller”), Buyer agreed to pay $3.4 billion in cash up front and up to $2.35 billion in earnouts, if the Seller’s robotic-assisted surgical devices achieved 10 regulatory and sales milestones, with each regulatory milestone expressly conditioned on obtaining 510(k) premarket notification.[1]  However, after the closing, the Food and Drug Administration (“FDA”) determined that these medical devices were no longer eligible for clearance through the 510(k) pathway.  The Buyer argued that the FDA’s closing of the 510(k) pathway, together with the fact that all eight of the regulatory milestones were conditioned on obtaining 510(k) premarket notification, excused Buyer’s obligations to continue to develop the Seller’s robotic technology.

The Court of Chancery rejected the Buyer’s argument and held that the implied covenant of good faith and fair dealing required the Buyer to pursue an alternative pathway for the first regulatory milestone known as a “de novo” review.

Supreme Court Reverses Implied Covenant Holding

The Delaware Supreme Court reversed the Court of Chancery’s holding that the Buyer had an implied obligation to pursue de novo review for the first milestone once the FDA closed the 510(k) pathway because there was no genuine contractual gap to fill.  The implied covenant of good faith and fair dealing should only be invoked if there is a contractual gap, and the doctrine should not be invoked to provide protections that could have been easily drafted by the parties at the bargaining table.

The merger agreement did not speak in general terms about “regulatory approval.”  Instead, it specifically conditioned each regulatory earnout on achieving “510(k) premarket notification.”  That drafting choice foreclosed any claim that the contract was silent about what form of FDA clearance would suffice.  Additionally, the FDA’s regulatory switch from 510(k) to de novo, although believed to be unlikely, was not unforeseeable at the time of contracting.  Finally, the Court of Chancery’s finding that the difference between 510(k) and de novo pathways for the first milestone would have an “immaterial effect on the time and cost” does not rescue the first milestone.  Immateriality does not rewrite a contractual requirement.

The remaining seven regulatory milestones—even though they also required 510(k) premarket notifications—were different according to the court.  Once the product received initial authorization through the de novo pathway, it could serve as its own predicate for the 510(k) pathway.  Consequently, the Delaware Supreme Court held that the Buyer remained obligated to use commercially reasonable efforts to pursue 510(k) clearance for the remaining milestones, including by seeking de novo authorization for an initial indication where necessary, to facilitate 510(k) clearance for subsequent indications.

Supreme Court Affirms Remainder of Court of Chancery’s Decision

The Buyer had agreed to a specifically defined “commercially reasonable efforts” clause that required the Buyer to pursue efforts consistent with its usual practice for a “priority medical device product.”  The Delaware Supreme Court upheld the Court of Chancery’s conclusion that the Buyer breached that obligation.  Additionally, the Delaware Supreme Court affirmed the Court of Chancery’s holding that a merger agreement’s exclusive remedy clause does not obviate the need for an express anti-reliance provision running against a seller.

Takeaway

Parties with an earnout can take comfort that Delaware courts are unlikely to rewrite the purchase agreement to add terms that could have been bargained for.  To invoke the implied covenant of good faith and fair dealing, the purchase agreement must have a genuine contractual gap.  More specificity on milestones will protect buyers and sellers from the risk of a court filling in gaps in unexpected ways, and if the regulatory pathway is key to the business model, it should be built into the milestone.

[1] Under the 510(k) pathway, a manufacturer seeks marketing authorization by showing that a new device is substantially equivalent to a legally marketed predicate device.  This route has historically been the fastest and least burdensome path to premarket authorization.  In contrast, the de novo pathway is intended for novel devices and typically requires more extensive data and a longer review.

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.