When a portion of the purchase price in an acquisition is
contingent on the earnings or other performance metric(s) of the
acquired business post-closing (i.e., an “earn-out”
provision), buyers and sellers routinely discuss their aspirations
and expectations regarding the go-forward operation and performance
of the acquired business during the transaction negotiations. These
discussions are a necessary part of arriving at the agreed
economics for the earn-out and also help the seller get comfortable
with the concept of an earn-out in the first instance. Despite the
frequency of these discussions, experienced and/or well-advised
buyers are generally opposed to including any specific operating
requirements or restrictions on the acquired businesses during the
earn-out period and most earn-out provisions preserve significant
(if not substantially complete) operational flexibility in favor of
the buyer. As a result, sellers frequently find themselves in a
position of needing to rely on their trust of the buyer to handle
matters as they discussed and expected, rather than on any express
obligations in the acquisition agreement.
The seller in the Delaware Chancery Court's decision
in Trifecta Multimedia Holdings Inc. and Dave Young v. WCG
Clinical Services LLC1 found itself in such a
situation. The case arises out of the sale by Dave Young (Young) of
his health care technology company, Trifecta Multimedia Holdings
Inc. (Trifecta), to WCG Clinical Services LLC (WCG) in a
transaction where a portion of the acquisition consideration
included an earn-out provision, which ultimately was not
achieved.
As described by the court in its opinion on WCG's motion to
dismiss,2 WCG made numerous promises to Young
regarding the post-closing operation of Trifecta's business
that were not included in the membership interest purchase
agreement governing the transaction (the Purchase Agreement), but
failed to follow through on such promises. WCG also took a number
of actions during the earn-out period that Young alleged were made
with an intention to frustrate the earn-out. Based on these
actions, Young asserted causes of action for, among other
things,3 fraud in the inducement (of entry into the
Purchase Agreement) and breach of the implied covenant of good
faith and fair dealing. The court allowed Young's fraud
claims largely to proceed, while it dismissed the breach of implied
duty claim.
Fraud Claim
In accordance with well-established law in Delaware, the elements of a fraud claim are: (1) a false representation, (2) the maker of such representation's knowledge of or belief in its falsity or reckless indifference to its truth, (3) an intention to induce action based on the representation, (4) reasonable reliance by the recipient on the representation, and (5) damages. The court spent considerable time in its opinion discussing the first and fourth prongs.
False “Representations”
According to Young, WCG made numerous promises during the
transaction negotiations that Young relied upon in selecting WCG as
the buyer, but were not included in the Purchase Agreement. Such
statements included oral statements made by (fairly senior)
representatives of WCG, as well as statements made by WCG in the
negotiated letter of intent the parties signed earlier in the sale
process.
WCG asserted that some of its alleged statements were not false
representations and instead merely constituted
“puffery.” Under Delaware law, “optimistic
statements praising [a counterparty's] own ‘skills,
experience, and recourses' are ‘mere puffery and cannot
form the basis for a fraud
claim.'”4 The court agreed with WCG
that several of its statements were “nothing more than
puffery” in that such statements were no more than
“vague statement[s] of ‘corporate optimism'
designed to boost WCG's appeal as a strategic partner. They
are classically vague statements that a commercial party routinely
makes during deal-making Courtship.”5 The
following statements made by WCG in relation to the post-closing
operation of Trifecta's business were characterized in this
manner:
- WCG would be “the best partner to accelerate growth” in Trifecta's business.
- The companies would be “shoulder to shoulder going after deals.”
- Trifecta would benefit from WCG's “collaboration, coordination and shared relationship across WCG's 4,000+ clients.”
- WCG would “support [Trifecta] with over 100 sales and marketing staff.”
Conversely, certain other statements allegedly made by WCG were considered by the court to be sufficiently specific to fall outside the bounds of puffery. While the court did not specifically list which statements did not constitute puffery, other statements by WCG included the following:
- A certain critical Trifecta product would be the “front door” for clients.
- A competing WCG product included in the earn-out revenue for purposes of the earn-out calculation would produce at least US$14 million in “guaranteed” revenue.
- “In the previous acquisitions and integrations WCG has completed, each of which were very successful, WCG has centralized the management of key corporate functions (chief financial officer, general counsel, etc.), while allowing each of the acquired divisions to continue to operate independently (including retaining all local corporate functions)…. [T]his operating structure provides the best environment for realizing the benefits of the combined business.”
Scienter
To establish the scienter/intent prong of Young's fraud claim, “the pled facts [must] support an inference that ‘at the time the promise was made the speaker had no intention of performing.'”6 The court relied on Young's allegations that WCG ceased performing almost immediately after the closing, including by preventing Trifecta personnel from speaking with potential customers and not hiring a replacement sales force, and determined that an inference of intent could be sufficiently drawn to survive a motion to dismiss.
Justifiable Reliance
The third prong of a fraud claim under Delaware law is
justifiable reliance. The Purchase Agreement included a fairly
typical “entire agreement” integration clause which
provided that it constituted the complete and entire agreement of
the parties, and superseded all prior and contemporaneous
understandings and agreements relating to the subject matter
thereof.
Relying upon the court's decisions
in Albertsons and Black Horse
Capital,7 WCG asserted that the existence of
such an integration clause would, in the context of a fraudulent
inducement claim, by itself constitute a contractual bar to a fraud
claim premised upon extra-contractual promises in the same way that
it has been established in Delaware
in Kronenberg and Abry
Partners8 that the inclusion of a provision in
which a party expressly and affirmatively states that it did not
rely on any representations and warranties not included in the
agreement would constitute a complete bar to fraud claims based
upon alleged extra-contractual promises. The Purchase Agreement
notably did not include such anti-reliance language.
The court noted that, in its view,
under Kronenberg and Abry
Partners,9 only explicit and unambiguous
non-reliance language would constitute a contractual bar to a
justifiable reliance claim. In doing so, the court directly and
specifically rejected WCG's contention
that Albertsons10 created an
exception to such requirement that would allow a standard
integration clause to constitute a bar to a contractual inducement
claim, separate and apart from a factual misrepresentation claim.
The court indicated that it viewed Albertsons, and
the Black Horse Capital decision that followed
it, as being inconsistent
with Kronenberg and Abry Partners,
and further noted that the view it expressed
in Trifecta on this issue constituted the
current majority position in Delaware. As a result, the court found
that Young's fraud claim would not fail on the basis that the
representations in question were made outside the Purchase
Agreement.
Damages
The court did not discuss Young's damages claim as a
distinct part of the fraud claim, but given that the core of
Young's complaint centers on the lost earn-out payment, the
final prong was sufficiently satisfied.
Accordingly, the court allowed Young's fraud claim to proceed
other than with respect to statements considered “mere
puffery.”
Implied Covenant of Good Faith and Fair Dealing
In addition to the fraud claim, Young alleged that WCG breached
the “implied covenant of good faith and fair dealing”
that was incorporated into the Purchase Agreement by engaging in
activities intended to frustrate the ability of Trifecta to achieve
earn-out revenue milestones. The court granted WCG's motion
to dismiss this claim.
According to the complaint, as part of the Purchase Agreement
negotiations, Young's transaction counsel proposed to include
an express requirement for WCG to undertake good faith efforts to
achieve the earn-out revenue milestones. WCG's counsel
responded that such a clause was unnecessary because, under
Delaware law, there was an implied covenant of good faith and fair
dealing which already obligated WCG to act in good faith to achieve
the milestones. Relying on this alleged mutual understanding, Young
did not insist on including an explicit obligation in the Purchase
Agreement.
As described by the Delaware Supreme Court in its Dieckman
v. Regency GP LP decision, under Delaware law,
“[t]he implied covenant is inherent in all contracts and is
used to infer contract terms to handle developments or contractual
gaps that … neither party anticipated. It applies when the
party asserting the implied covenant proves that the other party
has acted arbitrarily or unreasonably, thereby frustrating the
fruits of the bargain that the asserting party reasonably expected.
The reasonable expectations of the contracting parties are assessed
at the time of contracting.”11
The court noted that in order to invoke the implied covenant, there
must be a gap in the purchase agreement that needs to be filled.
The covenant will not be applied if: (1) there is no gap (i.e., the
language of the agreement covers a particular issue) or (2) there
is a gap because the parties negotiated over a term and rejected
it. Here, the parties specifically considered and discussed the
inclusion of an explicit efforts requirement, but elected not to do
so. The court held that, because the efforts requirement was
considered, there was no gap to fill by the implied covenant and
dismissed this claim.
The court also observed that, because Young's claim was predicated on the existence of a mutually agreed (albeit incorrect)12 understanding that the implied covenant of good faith and fair dealing incorporated a requirement into the Purchase Agreement for WCG to use good faith efforts to achieve the earn-out, the claim constituted a breach of contract claim rather than a breach of implied covenant claim. However, the court held that such a breach of contract claim fails because of its reliance on preliminary negotiations to prove the existence of an unwritten understanding of the parties where a standard “entire agreement” integration clause was included in the Purchase Agreement. To do otherwise, the court continued, would be inconsistent with the parol evidence rule in Delaware, which prohibits the admission into evidence and consideration of preliminary discussions or other types of parol evidence to demonstrate the existence of an additional agreement in the face of a standard integration clause.13
Finally, the court noted that Young might have been able to make a
claim for fraud based on the incorrect statements of Delaware law
made by WCG's counsel, but noted that such a claim would need
to be predicated on such counsel knowing that her statements were
false, which may or may not have actually been the case.
Accordingly, the court dismissed the claim.
Key Takeaways
- The distinction between statements identified by the court as “mere puffery” and those considered to be specific enough to be actionable is very slight and, with the exception of the guaranteed revenue statement, virtually impossible to identify. Notwithstanding the absence of a clear line, buyers operating under earn-outs should nonetheless be cautious about making statements that could be construed as specific promises regarding their future operations, in any format or forum (including letters of intent), to the extent possible.
- Assuming an agreement with an earn-out provision includes an integration clause and non-reliance language, counsel to sellers should impart upon their clients in the clearest (and starkest) terms possible the limitations on their ability to rely on extra-contractual earn-out related assurances, and to view the same on a purely “trust me” basis. Depending on the client, sellers may not expect those limitations and could possibly value the earn-out differently as a form of transaction consideration as a result. Delaware law does not include a requirement for buyers operating under earn-outs to use any particular level of efforts to achieve the same, although buyers may not take actions for the specific purpose of frustrating earn-outs. There would seem to be no advantage for a seller to attempt to remain silent on the efforts point during negotiations to preserve a potential “implied covenant” argument later.
- It is imperative that buyers, or any other party that is subject to an earn-out or earn-out like requirement, include explicit anti-reliance language in the agreement, in addition to including a standard integration clause. The inclusion of the anti-reliance provision should be no more controversial than the inclusion of an integration clause. Buyers should not rely on the court's prior decisions in Albertsons or Black Horse Capital as having created a distinction between fraudulent inducement claims and fraud claims premised on factual misrepresentations.
*Lily Cao contributed to this Advisory. Ms. Cao is a summer associate in the firm's Washington, D.C. office and will graduate in 2025 from University of California Hastings College of the Law. She is not admitted to the practice of law.
Footnotes
Trifecta Multimedia Holdings Inc. v. WCG Clinical Servs. LLC, No. 2023-0699-JTL, 2024 WL 2890980 (Del. Ch. June 10, 2024).
Because the court's opinion arises out of a motion to dismiss, all factual allegations made by Young in the complaint were accepted as true for purposes thereof (and derivatively, for purposes of this Advisory).
Young also asserted a claim for breach of contract resulting from a failure to deliver annual revenue statements and for indemnification under the acquisition agreement for losses arising from WCG's breach. The motion to dismiss such claims were both denied by the court.
Trifecta Multimedia, 2024 WL 2890980 at *9.
Id.
Id.
S'holder Representative Servs. LLC v. Albertsons Cos., Inc., 2021 WL 2311455 (Del. Ch. June 7, 2021); Black Horse Capital, LP v. Xstelos Holdings, Inc., 2014 WL 5025926 (Del. Ch. Sept. 30, 2014).
Kronenberg v. Katz, 872 A.2d 568 (Del. Ch. 2004); Abry P'rs V, L.P. v. F & W Acq. LLC, 891 A.2d 1032, 1050 (Del. Ch. 2006).
Id.
Albertsons, 2021 WL 2311455.
Dieckman v. Regency GP LP, 155 A.3d 358, 367 (Del. 2017).
Under Delaware law, in the absence of any express contractual obligation to the contrary, a buyer operating a business subject to an earn-out is not required to operate such business in a manner intended to ensure or maximize earn-out payments. Winshall v. Viacom Int'l, Inc., 76 A.3d 808, 811 (Del. 2013). Nonetheless, a buyer operating under an earn-out could be found to have breached the implied covenant where it took actions with the intention of negatively impacting the earn-out, such as shifting revenue out of the subject company for that purpose (American Capital Acquisition Partners, LLC v. LPL Holdings, Inc., 2014 WL 354496 (Del. Ch. Feb. 3, 2014)), or actively shifting costs onto the subject company for such purposes (Winshall, 76 A.3d 808).
Although not addressed by the court, such parol evidence would, on the contrary, be admissible under Delaware law to demonstrate the parties' understanding of an ambiguous provision. Here, the provision was absent, not vague or ambiguous.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.