“A Step You Can Take to Promote the Rule of Law” is the seventh article in a series on intersections between business law and the rule of law, and their importance for business lawyers, created by the American Bar Association Business Law Section’s Rule of Law Working Group. Read more articles in the series.
In January, the Rule of Law Working Group wrote about the important role of business lawyers as custodians of the Rule of Law. We observed that the Rule of Law is in decline globally, including in the United States, and highlighted the need for the legal profession to take a leadership role in strengthening that “durable system of laws institutions, norms, and community commitment” that has become synonymous with the Rule of Law.[1]
People with legal training should have a better appreciation of the essential role that the Rule of Law plays in our democracy. But we should not assume that people who are not members of the legal profession share that understanding.
When the Rule of Law is mentioned, the first reaction of the public, and many lawyers, is that the interests primarily implicated are those of people who are regularly involved in litigation. But the typical business lawyer no less than people who are regularly involved in litigation has a stake in a well-functioning legal system, and businesspeople have such a stake even when they are not engaged in litigation. This is because we have only one legal system. The principles and processes that apply to individuals and non-business issues also apply to businesses. Likewise, the system evolves, or deteriorates or is strengthened, systemwide.
When business lawyers pause and reflect on how the Rule of Law is the underpinning of the work they do on a daily basis in their professional lives, namely, “helping their clients navigate the legal landscape in which they operate,”[2] it becomes clear that business lawyers have as much a stake in the Rule of Law—if not a greater stake—as do people who are regularly engaged in litigation. We hope that such reflection motivates you to help strengthen the Rule of Law.
A Lumen Learning course on the Importance of Rule of Law to Business begins with an explanation of what is at stake for businesses as follows:
Can you imagine trying to do business without being able to have any reasonable expectations of other people’s behavior? Would you be willing to conduct business if you had no legal means by which to protect your property interests? And in the case of a dispute, without a rule of law system, there would be no established way to resolving it. Without the rule of law, business would be chaotic.[3]
The United States Chamber of Commerce has a Coalition for the Rule of Law in Global Markets. The Rule of Law Coalition observes that “The Rule of Law is among the most crucial factors in a company’s ability to do business profitably in any given market over time.”[4] It highlights the importance of transparency, predictability, stability, enforceability/accountability, and due process.[5] It is our hope that when you help businesspeople pause and reflect on how important the Rule of Law is to what they do on a daily basis, they too will be motivated to actively support the Rule of Law.
So what can you do, and will it make a difference?
The Rule of Law Working Group is promoting an initiative to recruit members of our Section to talk with a business client or a business group (e.g., local chamber of commerce or trade association) about a topic related to our legal system sometime during the month of May. We chose the month of May because Law Day[6] is May 1st, and it was established by President Dwight D. Eisenhower to celebrate the role of law in our society and to cultivate a deeper understanding of the legal profession. Members of Section leadership have already committed to participating.
The Rule of Law Working Group has identified a number of possible formats for such engagement with business clients or business groups. These include a talk followed by a question-and-answer period; a panel discussion with you as a moderator or one of the participants; a quiz or contest; a video presentation/slide show followed by a discussion involving the whole group or small groups; and inviting a client or group of clients to your office for lunch and any of the above. If you have any additional ideas, please pass them along to us, and we will share them. In the next few weeks, the Rule of Law Working Group will be posting on its website information about resources related to specific topics.
Your participation will make a difference, because it will take many of us, not just a few Section leaders, to have an impact. In The Tipping Point, Malcolm Gladwell writes about how ideas spread: “Ideas and products and messages and behaviors spread just like viruses do.”[7] He references “the mystery of the word of mouth—a phenomenon that everyone seemed to agree was important but no one seemed to know how to define.”[8] Gladwell observes “that we are about to enter the age of word of mouth, and that, paradoxically, all of the sophistication and wizardry and limitless access to information of the New Economy is going to lead us to rely more and more on very primitive kinds of social contacts.”[9]
Gladwell’s thesis finds support in our nation’s history, namely, the broad-based nature of the movement that led to the creation of our democracy. When students first learn about the American Revolution, they are taught stories about a few events and a few great men. But it is “We the people” who make things happen. As Ray Raphael writes in Founding Myths,
In popular narratives, only leaders function as agents of history. They provide the motive force; without them, nothing would happen. The famous founders, we are told, made the American Revolution. They dreamed up the ideas, spoke and wrote incessantly, and finally convinced others to follow their lead. But honoring these people as the architects of our nation’s independence is like honoring Lyndon Johnson as the architect of civil rights. In both cases, powerful men finalized the deal, but others placed the deal on the table and pushed it forward. [10]
So we hope you will take the step we suggest, with other members of your Section, to promote the Rule of Law so that together we can have a meaningful impact. If you are willing to join in this initiative, please contact Lakshmi Gopal at [email protected], and we will put you on the list of participants so that we can keep you updated.
For the Rule of Law Working Group,
John H. Stout, Co-Chair Alvin W. Thompson, Co-Chair Lakshmi Gopal, Vice Chair
Bankruptcy practitioners across the United States are all too familiar with the Chapter 11 case of Neiman Marcus Group Ltd, LLC[1] (“Neiman Marcus”). Most restructurings under the Bankruptcy Code involve at least a few surprises, as debtors progress toward plan confirmation. Few include a committee chairman violating his fiduciary duties and serving prison time for conduct during the case. On February 3, 2021, Daniel Kamensky, founder and manager of Marble Ridge Capital, LP (“Marble Ridge”)—the former co-chair of the Official Committee of Unsecured Creditors in Neiman Marcus’ Chapter 11 case—pled guilty to bankruptcy fraud in the United States District Court for the Southern District of New York.[2] Kamensky was sentenced to six months in prison, plus six months of supervised release under home detention and a $55,000 fine.
The ordeal stemmed from a global settlement resolving potential claims for fraudulent transfers of substantially all of the equity in the retail giant’s e-commerce unit, MyTheresa, to its parent company, Neiman Marcus Group, Inc. (the “Parent Company”). The settlement called for the Parent Company to distribute 140 million shares of Series B preferred shares in MyTheresa for distribution to general unsecured creditors. To create liquidity for unsecured creditors, Marble Ridge agreed to backstop the purchase of 60 million shares at $0.20 per share.[3] But those shares were subject to an (unofficial) higher and better offer by Jefferies Financial Group, Inc. (“Jefferies”) for the purchase of 140 million shares at somewhere between $.30 and $.40 per share.[4]
After discovering the competing offer, Kamensky exploited his role as Chairman of the Committee to pressure Jefferies into abandoning its bid.[5] Within 24 hours, Kamensky contacted representatives at Jefferies, threatening to discontinue Marble Ridge’s business relationship with Jefferies if it did not cease all efforts to bid on the equity.[6] And the rest is history.
Neiman Marcus’ Chapter 11 case illustrates an issue often faced by practitioners and their clients serving as members of a creditors’ committee. Although creditors generally share a common goal of maximizing the value of the estate, each creditor’s individual interests create an inherent conflict. Members must often wear two hats and balance competing interests between their constituencies. This begs the question, what should committee members do once they encounter confidential information in the course of their duties? The answer is simple: play by the rules. The inherent tension amongst the member’s own interests, the committee’s interests, and those of the general creditor body underscores the need for strict compliance with governance procedures. In most cases, committees will adopt bylaws through which members can resolve disputes or conflicts of interest. Counsel should ensure that the bylaws address several key aspects of committee operations, including how to resolve conflicts of interests and to handle confidential information.
Part I of this article provides an overview on the appointment of a committee and the legal authority governing a committee member’s fiduciary duties. Part II provides an overview of the pertinent facts preceding and during the Neiman Marcus Chapter 11 case. Part III summarizes best practices for committee counsel to properly manage conflicts of interest. Part IV concludes with key takeaways.
Part I: The Unsecured Creditors’ Committee: Role, Powers, Duties
The Bankruptcy Code contemplates that the Official Committee of Unsecured Creditors (“Committee”) plays a critical role in a bankruptcy case.[7] Section 1102(a) of the Bankruptcy Code requires the United States Trustee to appoint the Committee and, in appropriate cases, additional creditor or equity committees:[8] “[A]s soon as practicable after the order for relief under chapter 11 of this title, the United States Trustee shall appoint a committee of creditors holding unsecured claims and may appoint additional committees of creditors or of equity security holders as the United States Trustee deems appropriate.”[9] The bankruptcy court may, however, order the appointment of additional committees of creditors or of equity security holders if necessary to assure adequate representation of creditors or of equity security holders.[10] If the court orders the appointment of an additional committee, “the United States trustee shall appoint any such committee.”[11]
Once appointed by the trustee, the Committee functions as the proverbial “watchdog” on behalf of the body of creditors it represents. Section 1103(c) of the Bankruptcy Code sets forth the powers and duties of committees appointed under Section 1102, including: “consult[ing] with the trustee or debtor in possession concerning the administration of the case” and “investigat[ing] the acts, conduct, assets, liabilities and financial condition of the debtor, the operation of the debtor’s business and the desirability of the continuance of such business, and any other matter relevant to the case or to the formulation of a plan.”[12]
The Committee advances the interests of the class of creditors at each stage of the bankruptcy process “to arrive at a plan that can be confirmed under section 1129.”[13] In that regard, the Committee serves as a fiduciary for the class of creditors as whole.[14] Courts have long recognized that members of the Committee assume a fiduciary obligation to other members, the creditors whom they were elected to represent.[15] In exercising that fiduciary duty, the committee must “guide its actions so as to safeguard as much as possible the rights of minority as well as majority creditors.”[16] The Committee must be “honest, loyal, trustworthy and without conflicting interests.”[17]
But that duty is not limitless. The Committee’s fiduciary obligations create constant tension with an individual member’s right to advance its own interests. A Committee member’s fiduciary obligations do not render its own interests meaningless.[18] Creditors’ individual interests are not required to perfectly align with the interests of the class as a whole.[19] Committees often include creditors with differing or even conflicting interests.[20] Unlike a debtor-in-possession, the committee is not a fiduciary of the estate. Courts generally recognize that “[n]o two creditors have identical interests.”[21] Committee members are “hybrids who serve more than one master. Every member of the Committee is, by definition a creditor. Thus, she is in competition with every other creditor for a piece of a shrinking pie. She may assert her rights as a creditor to the detriment of the creditor body as a whole without running afoul of her fiduciary obligations.”[22]
Individual members may act in their own best interest as long as the action does not injure other creditors. Committee members must avoid conflicts of interest that might compromise their loyalty to the creditor class and cannot use their positions on the Committee to further their own self-interest to the detriment of the class.[23] Should a conflict arise and its constituents, the majority of courts will not necessarily require that the classes’ interest take priority as a matter of law if the members does not use his position to the detriment of other creditors.
Part II: Neiman Marcus
Kamensky’s misconduct was the bitter finale of a longstanding dispute between Marble Ridge and the sole owners of Neiman Marcus’s Parent Company, Ares Capital and the Canadian Pension Plan Investment Board (collectively, the “Sponsors”). The dispute centered on a stock transfer of the retail giant’s relatively profitable e-commerce unit, MyTheresa. In 2018, Neiman Marcus disclosed that it transferred substantially all of its equity in MyTheresa to the Parent Company at the behest of the Sponsors.
The transaction sparked outrage amongst Neiman Marcus’s creditors. Marble Ridge believed that Neiman’s bankruptcy was inevitable and that Neiman Marcus fraudulently transferred the shares to the Parent Company to divert a valuable asset away from Neiman’s creditors. The transaction was subject of two state court lawsuits filed by or on behalf of Marble Ridge.[24]
The state litigation continued for over a year until Neiman Marcus filed for Chapter 11 relief in the United States Bankruptcy Court for the Southern District of Texas on May 7, 2020. Shortly thereafter, the United States Trustee appointed the Official Committee of Unsecured Creditors. Marble Ridge served as a member on the Committee and Marble Ridge managing partner, Daniel Kamensky, was subsequently elected as one of three co-chairs.
In hindsight, it seems that Marble Ridge’s appointment was the root of Kamensky’s problems. The parties eventually agreed to a global settlement under which the Parent Company would contribute preferred equity in MyTheresa to the estate for the benefit of unsecured creditors. Marble Ridge initially offered to play the role of white knight, agreeing to purchase 60 million shares at $.20 per shares.[25] But on July 31, 2020, Jefferies expressed an interest in placing a higher bid on the preferred equity to the Committee’s financial advisor.[26] The unofficial bid would have topped Marble Ridge’s offer at somewhere between $.30 and $.40 per share.[27]
Kamensky was outraged. Within minutes of learning that Jefferies was the competing bidder, Kamensky contacted representatives of Jefferies through a series of texts and Bloomberg chat messages to “stand DOWN,”[28] “DO NOT SEND IN A BID, ”[29] and even threatened to use his position as co-chair of the Committee to prevent Jefferies from bidding on MyTheresa’s shares.[30] Worse, Kamensky leveraged Marble Ridge’s ongoing business relationship with Jefferies to provide the investment bank’s representatives an ultimatum:[31] Cease all efforts to bid on MyTheresa’s equity, or Marble Ridge would cease doing business with Jefferies and they would no longer be partners moving forward.[32] Jefferies never placed a bid on the preferred equity and disclosed to the Committee that its decision was a result of Kamensky’s demands.[33]
Unfortunately, that disclosure prompted Kamensky to make a bad situation even worse. On July 31, 2020, Kamensky contacted a Jefferies’ representative and demanded to know why the investment bank disclosed their discussions to the Committee.[34] Kamensky stated that if Jefferies continued to cooperate with the Committee, “I’m going to jail, okay? Because they’re going to say that I abused my position as a fiduciary, which I probably did, right? Maybe I should go to jail. But I’m asking you not to put me in jail.”[35] He then urged Jefferies to take part in the bidding process,[36] and in an apparent attempt to undo the harm, stated to the representative that the “conversation never happened.”[37]
The end of the story did not bode well for Marble Ridge or Kamensky. On August 5, 2020, the bankruptcy court charged the United States Trustee with conducting an investigation. The bankruptcy court found that “the substantial evidence collected to date clearly demonstrates that … Kamensky breached his fiduciary duty to unsecured creditors on July 31 … After being told of the existence of a rival bid and the identity of the bidder, Mr. Kamensky sought to exploit that information for his benefit by contacting Jefferies and pressuring them to withdraw their initial bid, to the likely detriment of all other creditors.”[38]
On August 20, 2021, Marble Ridge notified investors of its plan to wind down its funds and liquidate over $1 billion in assets under management.[39] On September 3, 2020, Kamensky was arrested and charged for fraud during the offer or sale of securities, bribery, and obstruction of justice. On February 3, 2021, Kamensky pled guilty to one count of bankruptcy fraud and thereafter was sentenced to serve six months in prison.
As for MyTheresa, the preferred shares were distributed directly to unsecured creditors, and on January 25, 2021, MyTheresa had an initial public offering. Since then, the shares have traded in excess of $35 a share—a far cry from the $0.20 offer that Marble Ridge initially made.
Part III: Conflict—You Cannot Avoid It
Kamensky’s fate could have been avoided. And this article is in no way intended to suggest that Committee counsel did anything wrong here. The reality is that Kamensky simply failed to play by the rules and failed to follow what the committee bylaws likely required. Kamesnky could have disclosed his intentions to the committee counsel before taking any action in connection with the bidding process. Better yet, as soon as Kamensky determined he had an interest in potentially participating, he could have resigned from the Committee altogether. Of course, we know he did neither.
Plainly, the role of Committee counsel can be very challenging. In order for a Committee to effectively fulfill its duties in a case, members should have full and complete access to information concerning the debtor’s affairs.[40] That information invariably includes confidential information that could be misused for competitive or operational reasons. In this regard, the role of Committee counsel contemplates the identification, management, and resolution of conflicts of interest in real time and on a proactive basis. This requires counsel to anticipate, identify, and resolve conflicts in the ordinary course. This challenge in turn requires counsel to have in place restrictions and procedures to mitigate the temptation for possible self-dealing by members.
The interests of an individual member, the Committee, and the creditor class as a whole may not always align. While the collective goal of value maximization will generally encompass the interests of members, participation on a committee is generally driven by self-interest.[41] Committee counsel must be mindful of these competing interests, as the engagement will often extend far beyond the normal role of an advocate.[42] Counsel will wear a number of hats as an educator, advisor, and intermediary of Committee and inter-creditor disputes.[43] And to succeed in this regard, counsel must effectively anticipate and manage potential conflicts, including the following best practices.
Committee Governance. Committee counsel should immediately draft and implement Committee bylaws to address and manage conflicts of interest. The bylaw provisions should:
impose upon each member a continuing obligation to disclose any and all prior connections with the debtor and other parties in interest, all economic interests related to the Debtor, including claims, ownership interests, competitive interests, and contracts, as well as any actual or potential conflicts that may arise;
include limitations on access to information that may potentially serve any of the potential conflicts or competing interests;
delineate procedures to vet and select a chairperson; and
provide for exclusion of a member from Committee participation on any matter on which the member is determined to have an actual or potential conflict of interest, provided that the member can take independent action that does not result in a breach of any fiduciary obligation as a Committee member (in which case that member should resign from the Committee).
Under the guidance of counsel, the Committee must insist upon complete disclosure of the nature and components of each member’s claims and other interests related to the debtor. Should the Committee fail to provide a procedure for members to assert their individual positions and differentiate those actions from measures undertaken by the Committee, the fiduciary duties of all of the members may be compromised.
Voting Procedures. Bylaws of the Committee should also address voting procedures as soon as possible after committee formation. These procedures should include vehicles for breaking ties, particularly where one or more members must abstain. The challenge is anticipating what changes will occur of the course of the case. In many instances, the dynamics of the Committee can quickly shift. For example, with larger committees appointed in cases that run longer, some members may become less active or entirely inactive as the case progresses. The potential for misconduct or abuse of the Committee process can increase as inactive members are asked to vote on critical issues, perhaps regarding plan formulation, about which they may be less informed and more reliant on other members or counsel. As a safeguard to limit this potential for abuse, most creditors’ Committees prohibit voting by proxy and may implement a minimum quorum to vote on substantive matters at meetings.
Protective Orders. In most cases, the debtor requires the Committee and its members to execute a confidentiality agreement or protective order concerning the disclosure of non-public information. Protective or confidentiality orders generally prohibit disclosure, use or dissemination of non-public information obtained through Committee membership. The information provided to the Committee, either from non-public sources or from analyses by the debtor’s or Committee’s professionals, as well as the deliberations of the Committee, must be kept in strict confidence. And the level of scrutiny and restriction must be heightened in the circumstance of a committee member conflict. It is not enough to simply have the member abstain from voting; the bylaws should require the withholding of confidential information, deliberations, and even the final votes from those committee members who are forced by conflicts to abstain. Strict compliance with confidentiality restrictions encourages the free-flowing production and sharing of information between the debtor and Committee, which is necessary to facilitate a successful and ideally consensual reorganization.
Moreover, a confidentiality agreement or protective order may heighten the members’ awareness of the appropriate (and inappropriate) uses (or misuses) of information and the need for limiting disclosure to properly conduct the tasks of the Committee. The confidentiality agreement or protective order will generally restrict the members’ use of confidential information acquired only through the Committee membership. But cases can move quickly, and thus members who fail to sign the confidentiality agreement must be excluded from disclosures and discussions involving confidential Committee information until they sign. The early stages of a committee appointment are ripe for lax enforcement and abuse, but the beginning is the best time to make clear the importance of strict compliance.
Part IV: Key Takeaways
The representation of Committees in bankruptcy proceedings will almost always involve the management and control over a free flow of information between and among the debtor, Committee members, and the Committee’s professionals. For Committee counsel, that information should include early and ongoing disclosure by all members of their interests and connections in the debtor and the proceedings. In the course of service on the committee, members will invariably encounter confidential information that could be used to their own benefit or to other’s detriment. Committee counsel must anticipate and implement appropriate safeguards to manage and resolve these potential conflicts before they occur. Practitioners representing Committees should be acutely aware of the inevitability of the conflicts that arise when members receive proprietary information during the course of a case. Under those circumstances, Committee counsel and members should look to their governance documents and conscience for guidance. Put clear procedures in place, enforce those procedures strictly, and always, always err on the side of caution.
In re Neiman Marcus Group LTD, LLC, et al., No. 20-32519 (DRJ) (Bankr. S.D. Tex. Aug. 19, 2020) (Jointly Administered). ↑
Statement of the Acting United States Trustee Pursuant to Court Order Regarding the Conduct of Marble Ridge Capital LP & Dan Kamensky at 22, In re Neiman Marcus Group LTD, LLC, et al., No. 20-32519 (DRJ) (Bankr. S.D. Tex. Aug. 19, 2020), ECF No. 1485 (the “Report”). ↑
See James White & Raymond Nimmer, Bankr. Cases and Mat. 65 (3d ed. 1996); see also In re STN Enter., 779 F.2d 901, 905 (2d Cir. 1985) (granting committee standing to sue); In re A. C. Williams Co., 25 B.R. 173, 177 (Bankr. N.D. Ohio 1982) (stating committee should be active in arriving at plan). See generally 11 U.S.C. § 1129 (1994) (providing for prerequisite for confirmation of restructuring plan). ↑
See Westmoreland Human Opportunities, Inc. v. Walsh, 246 F.3d 233, 256 (3d Cir. 2001). ↑
In re Enduro Stainless, Inc., 59 B.R. 603, 605 (Bankr. N.D. Ohio 1986) (stating that member of creditors’ committee undertakes to act in fiduciary capacity and may not act as to promote only that creditors’ interest); In re Bohack Corp., 607 F.2d 258, 262 n.4 (2d Cir. 1979) (“[T]he committee owes a fiduciary duty to the creditors, and must guide its actions so as to safeguard as much as possible the rights of minority as well as majority creditors”). ↑
Shaw & Levine v. Gulf & Western Indus. (In re Bohack Corp.), 607 F.2d 258, 262 n.4 (2d Cir. 1979). ↑
In re Johns-Manville Corp., 26 B.R. 919, 925 (Bankr. S.D.N.Y. 1983); see also In re Tucker Freight Lines Inc., 62 B.R. 213, 216 (Bankr. W.D. Mich. 1986) (“At a minimum, this fiduciary duty requires that the committee’s determinations must be honestly arrived at, and, to the greatest degree possible, also accurate and correct.”). ↑
Official Unsecured Creditors’ Comm. v. Stern (In re SPM Mfg. Corp.), 984 F.2d 1305, 1317 (1st Cir. 1993) (citation omitted). ↑
See, e.g., In re Plabell Rubber Prods., Inc., 140 B.R. 179, 181 (Bankr. N.D. Ohio 1992) (stating that all committee members need not have parallel interests); In re Texaco, Inc., 79 B.R. 560, 567 (Bankr. S.D.N.Y. 1987). ↑
In re Microboard Processing, Inc., 95 B.R. 283, 285 (Bankr. D. Conn. 1989). ↑
SPM Mfg. Corp., 984 F.2d at 1317 (citation omitted). ↑
In re Rickel & Associates, Inc., 272 B.R. 74 (Bankr. S.D.N.Y. 2002). ↑
Johns-Manville, 26 B.R. at 925 (“Conflicts of interest on the part of representative persons or committees are thus not [to] be tolerated.”); In re Haskell-Dawes Inc., 188 B.R. 515, 522 (Bankr. E.D. Pa. 1995) (committee members have a fiduciary duty that prohibits them from “using their position to advance their own individual interests”). ↑
See, e.g., In re Channel Master Holdings, Inc., 309 B.R. 855, 862 (Bankr. D. Del. 2004) (holding that creditors’ committee was entitled to review and oppose debtor’s Key Employee Retention Plan). ↑
See In re Microboard Processing, Inc., 95 B.R. 283, 285 (Bankr. D. Conn. 1989) (describing inherent conflict of interest of unsecured creditors as axiomatic). ↑
See Texas Extrusion Corp. v. Lockheed Corp. (In re Texas Extrusion Corp.), 844 F.2d 1142, 1163 (5th Cir. 1988) (authorizing attorney for creditors’ committee to consult with creditors); In re Wire Cloth Prod., 130 B.R. 798, 812 (Bankr. N.D. Ill. 1991) (stating that attorneys for creditors’ committee must further economic interests of unsecured creditors); In re Pettibone Corp., 74 B.R. 293, 309 (Bankr. N.D. Ill. 1987) (delineating counsel’s functions necessary to creditors’ committee performance). ↑
See generally Carl A. Eklund & Lynn W. Roberts, The Problem with Creditors’ Committees in Chapter 11: How to Manage the Inherent Conflicts Without Loss of Function, 5 Am. Bankr. Inst. L. Rev. 129, 138 (1997). ↑
Economists have long argued that economic activity influences businesses filing for bankruptcy. This relationship is grounded in the simple idea that economic downturns can sufficiently reduce liquidity such that debtors are unable to meet debt obligations as they become due and might require court-driven solutions.[1]
Indeed, in the past two years a lengthy list of companies filed for bankruptcy in a wide array of industries, including: retail, commercial real estate, leisure and travel, air travel, restaurant and food service, energy, and communications.[2]
Filings and Economic Activity
To illustrate the relationship between bankruptcy filings and economic activity, one can observe bankruptcy filings over the business cycle. The two Figures below show the seasonally adjusted number of Chapter 7 and Chapter 11 filings (two common forms of bankruptcy) and an index of economic activity published by the Federal Reserve.[3]
Figure 1: Business Chapter 7 Filings and Coincident Economic Activity Index
2013 ̶ Sep 2021
Figure 2: Business Chapter 11 Filings and Coincident Economic Activity Index
2013 ̶ Sep 2021
Both Figures show that up until the start of the COVID-19 recession, the continued expansion of economic activity generally corresponded with a reduction in filings for Chapter 7 and Chapter 11. In other words, there is an inverse relationship between the number of filings and the level of economic activity. But Figure 1 also illustrates that the economic contraction in 2020 corresponded with a sharp decline in Chapter 7 filings, rather than the increase in filings predicted by the historic relationship between the two indicators. Business Chapter 11 filings, on the other hand, increased even if not as much as the historical relationship would indicate.
Therefore, these Figures pose a relevant question: Has the most recent economic downturn been associated with levels of bankruptcy filings similar to those in the past? And, if the number of filings didn’t follow the historical pattern, what can explain the new trend?
Recent Filing Rates
To help answer these questions, we next compare monthly filings in each of 2020 and 2021 to those that occurred during the same month of 2019. This comparison should help control for factors other than the COVID-19 recession. We also break down bankruptcy filings into business and non-business Chapter 7 and business Chapter 11.
Figure 3: Business and Non-Business Bankruptcy Filings
2020 ̶ Sep 2021 (Benchmark Year = 2019)
Confirming the pattern presented above, Figure 3 shows that both non-business and business Chapter 7 filings (which tend to be associated with small-to-medium size companies) were down in 2020, compared to 2019. And the number of cases did not reach the 2019 levels in the first three quarters of 2021 either. In contrast, Chapter 11 filings were significantly higher in 2020, compared to 2019. However, this trend reverted in 2021 with filings on average 28% lower than 2019 levels.
Hypotheses and Explanations
A group of economists have analyzed the rate of bankruptcy filings during 2020 in deeper detail and found comparable results. They further reported, for example, that filings by companies with asset value greater than $50 million increased by nearly 200% in 2020.[4]
As shown in Figure 3, small-to-medium businesses (and households) have filed for bankruptcy less frequently than what might have been expected. The economists provide a list of potential reasons why this might have happened, including: policy responses, access to bankruptcy courts, liquidity, and uncertainty. We explain these factors next.
The first factor refers to policy responses which might have contributed to differing filing rates among different economic actors. Policy responses such as the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) (which included a foreclosure moratorium), the Paycheck Protection Program (“PPP”), and other measures activated by state and local governments reduced the demand for bankruptcy protection among households and smaller businesses.[5] To the extent these policies targeted smaller business and households, this factor would explain the decline in their filing rate. On the other hand, the CARES Act expanded on a new law that streamlined the Chapter 11 process (the Small Business Reorganization Act (“SBRA”)).[6] Specifically, the CARES Act raised the debt threshold required to take advantage of the streamlined Chapter 11 process envisioned under the SBRA, allowing for a larger pool of eligible companies. This could explain part of the observed increase in Chapter 11 filings.[7]
Second, households and smaller businesses may have had trouble accessing bankruptcy courts—and meeting with any bankruptcy counsel they might have retained—because of pandemic-induced changes in court operations. More difficult access to bankruptcy courts would naturally translate into less filings.[8] A related factor is that busier courts could have hindered small companies’ opportunity to file. A study shows that as bankruptcy courts see higher caseloads, the focus shifts towards larger companies at the expense of smaller ones.[9]
Third, economists have found that the existence of bankruptcy fees generally prevents households from filing. For example, a study using data from 2001 and 2008 tax rebates found that consumers who received a tax rebate increased their propensity to file for bankruptcy compared to those that did not.[10] This theory would suggest that if households or smaller businesses had constrained liquidity during the COVID-19 recession, they would have been less likely to file bankruptcy. On the other hand, an increase in liquidity would correspond to an increase in filings. This theory would be consistent with the increase in Chapter 7 filings immediately following April 2020, when the first stimulus check was distributed (and the PPP bill was signed). However, an increase in filings is not apparent after the stimulus checks distributed in December 2020 and March 2021, respectively.[11]
Lastly, the uncertainty surrounding the COVID-19 pandemic may have contributed to the slower household bankruptcy filing rates. Because households typically must wait 8 years before they can file for Chapter 7 a second time, economists argue that there is a benefit to waiting and seeing how pervasive an economic crisis is before filing for bankruptcy.[12] For businesses, a wait-and-see policy is likely more valuable for Chapter 7 compared to Chapter 11 because the former implies liquidating assets whereas the latter is often a reorganization of the business. This hypothesis explains the lower filing rates experienced by households and smaller businesses but would also predict an increase in these filings when (and if) COVID-related uncertainty dissipates, everything else being equal. A look at Figure 3 indicates that if this hypothesis is true, uncertainty remained high during the period we collected data for.
Conclusion
In summary, while economic research continues to produce insights into the broad implications of the COVID-19 pandemic, this article highlighted that COVID-related effects on bankruptcy filings by households and small businesses were different than the effects on larger companies, at least in 2020. The 2021 data indicates that this difference has largely disappeared even though filings for bankruptcy remain lower than 2019 levels. Further statistical analysis can provide clues as to the importance of the potential causes for the trends explained in this article.
For example, seminal work by Prof. Altman showed that bankruptcy can be predicted by financial ratios such as working capital to total assets, retained earnings to total assets, EBIT to total assets, market equity to total liabilities, and sales to total assets. See Edward Altman, “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy,” Journal of Finance 23, 1968, pp. 589–609. ↑
A partial list of corresponding companies includes J.C. Penney, Neiman Marcus, Lord & Taylor, Pennsylvania Real Estate Investment Trust, Hertz, LATAM, Sizzler, Chesapeake Energy, Diamond Offshore Drilling, and Frontier. ↑
See Federal Reserve Bank of Philadelphia, Coincident Economic Activity Index for the United States [USPHCI], retrieved from FRED, Federal Reserve Bank of St. Louis. Available at http://fred.stlouisfed.org/series/USPHCI. ↑
Jialan Wang, Jeyul Yang, Ben Iverson, and Renhao Jiang, “Bankruptcy and the COVID-19 Crisis,” Working Paper, March 2021. ↑
Robin Greenwood, Ben Iverson, and David Thesmar, “Sizing Up Corporate Restructuring in the Covid Crisis,” Brookings Papers on Economic Activity, Fall 2020 (Special Edition): 391-428. Seealso, Alan Hochheiser, “Consumer Bankruptcy in the Age of COVID-19,” Business Law Today, American Bar Association, June 25, 2021. ↑
Paige Marta Skiba, Dalie Jimenez, Michelle McKinnon Miller, Pamela Foohey, and Sara Sternberg Greene, “Bankruptcy Courts Ill-Prepared for Tsunami of People Going Broke from Coronavirus Shutdown,” The Conversation, May 2020. See, also, Bob Lawless, “A Coming Consumer Bankruptcy Tsunami, Wave, or Ripple?” Available at https://www.creditslips.org/creditslips/2020/04/a-coming-consumer-bankruptcy-tsunami-wave-or-ripple.html. ↑
Ben Iverson, “Get in Line: Chapter 11 Restructuring in Crowded Bankruptcy Courts,” Management Science 64 (11), 2018, 4967-5460. ↑
Tal Gross, Matthew Notowidigdo, and Jialan Wang, “Liquidity Constraints and Consumer Bankruptcy: Evidence from Tax Rebates,” Review of Economics and Statistics, 2014, 96(3), 431-443. ↑
Tal Gross, Raymond Kluender, Feng Liu, Matthew J. Notowidigdo, and Jialan Wan, “The Economic Consequences of Bankruptcy Reform,” National Bureau of Economic Research Working Paper #26254, 2020. See, also, Michelle White, “Why Don’t More Households File for Bankruptcy?” Journal of Law, Economics, & Organization, 1998, pp. 205-231. ↑
February 2022 saw several court decisions concerning the Illinois Biometric Information Privacy Act (“BIPA”) (740 ILCS 14/1 et seq.). Regarding the two state court decisions, one looks at the exclusivity provisions of the Illinois Workers’ Compensation Act in the light of BIPA, and the other examines Section 301 of the Labor Management Relations Act (29 U.S.C. §185) and how BIPA reflects on collective bargaining agreements. This article provides a brief review of each of these two cases and concludes with some thoughts for business leaders to reflect upon when considering their BIPA compliance and potential liabilities.
BIPA and Workers’ Compensation
In a February 3, 2022, decision, the Illinois Supreme Court held that the exclusivity provisions of the Illinois Workers’ Compensation Act [(“Compensation Act”) (820 ILCS 305/1 et seq.)] do not bar a claim for statutory damages under the Biometric Information Privacy Act (“BIPA”) where an employer is alleged to have violated an employee’s statutory privacy rights under BIPA.
The plaintiff (employee) in McDonald v. Symphony Bronzeville Park, LLC, et al., 2022 WL 318649 (Illinois Supreme Court, 20220203) was seeking damages under BIPA and attempting to form a class. The defendants (the employer) filed a motion to dismiss the plaintiff’s class action complaint, asserting, inter alia, that plaintiff and the putative class’s alleged claims were barred by the exclusive remedy provisions of the Compensation Act. In particular, defendant argued that the Compensation Act is the exclusive remedy for accidental injuries transpiring in the workplace and that an employee has no common-law or statutory right to recover civil damages from an employer for injuries incurred in the course of her employment.
In its analysis the Illinois Supreme Court stated, “The personal and societal injuries caused by violating the Privacy Act’s prophylactic requirements are different in nature and scope from the physical and psychological work injuries that are compensable under the Compensation Act. The Privacy Act involves prophylactic measures to prevent compromise of an individual’s biometrics. Rosenbach, 2019 IL 123186, ¶ 36 [432 Ill.Dec. 654, 129 N.E.3d 1197]. McDonald’s [plaintiff’s] claim seeks redress for the lost opportunity ‘to say no by withholding consent.’ Id. ¶ 34. McDonald [plaintiff] alleges that Bronzeville [employer] has violated her and the class’s right to maintain their biometric privacy. See id.” (For a more detailed discussion of Rosenbach, see “Biometric Information – Permanent Personally Identifiable Information Risk” available at http://bit.ly/BIP-PII-RISK-ABA-BUS-CORP-LIT20190702.)
The Illinois Supreme Court distinguished the different purposes of the Compensation Act and BIPA and commented on the legislative intent:
We are cognizant of the substantial consequences the legislature intended as a result of Privacy Act violations. Pursuant to the Privacy Act, the General Assembly has adopted a strategy to limit the risks posed by the growing use of biometrics by businesses and the difficulty in providing meaningful recourse once a person’s biometric identifiers or biometric information has been compromised. Rosenbach, 2019 IL 123186, ¶ 35 [432 Ill.Dec. 654, 129 N.E.3d 1197]; see also 740 ILCS 14/5(c) (West 2016) (once biometrics are compromised, the individual has no recourse, is at heightened risk for identity theft, and is likely to withdraw from biometric-facilitated transactions). The General Assembly has tried to head off such problems before they occur by imposing safeguards to ensure that the individuals’ privacy rights in their biometric identifiers and biometric information are properly protected before they can be compromised and by subjecting private entities who fail to follow the statute’s requirements to substantial potential liability (740 ILCS 14/20 (West 2016)) whether or not actual damages, beyond violation of the law’s provisions, can be shown. Rosenbach, 2019 IL 123186, ¶ 36 [432 Ill.Dec. 654, 129 N.E.3d 1197]. “It is clear that the legislature intended for this provision to have substantial force.” Id. ¶ 37.
“When private entities face liability for failure to comply with the law’s requirements without requiring affected individuals or customers to show some injury beyond violation of their statutory rights, those entities have the strongest possible incentive to conform to the law and prevent problems before they occur and cannot be undone.” Id.
BIPA and Collective Bargaining Agreements
In a February 22, 2022, decision, the Appellate Court of Illinois, First District, held that plaintiff (union employee) and his fellow unionized employees are not prohibited from pursuing redress for a violation of their right under BIPA to biometric privacy—they are simply required to pursue those rights through the grievance procedures in their collective bargaining agreement rather than in state court in the first instance. In essence, the Illinois Appellate Court determined that a union member-employee (plaintiff) “cannot bypass his union, his sole and exclusive bargaining agent,” to demand that the employer “deal with him directly” on this issue.
The plaintiff (union member-employee) in William Walton, Individually and on Behalf of Others Similarly Situated, v. Roosevelt University, 2022 WL 522760 (Appellate Court of Illinois, 1st District, 2nd Division, 20220222) alleged claims under BIPA. The defendant argued that the claims asserted by the plaintiff are preempted and moved to dismiss the complaint. The circuit court denied the motion to dismiss but certified the relevant question (“Does Section 301 of the Labor Management Relations Act (29 U.S.C. § 185) preempt [Privacy Act] claims (740 ILCS 14/1) asserted by bargaining unit employees covered by a collective bargaining agreement?”) for interlocutory review.
The Illinois Court of Appeals noted that while the Walton appeal was pending, the United States Court of Appeals for the Seventh Circuit directly addressed the question brought to bear in this appeal. In Fernandez v. Kerry, Inc., 14 F.4th 644, 646-47 (7th Cir. 2021), the U.S. court of appeals found that unionized employees’ claims that their employer violated the BIPA were preempted by the Labor Management Relations Act (29 U.S.C. § 185). As Walton (plaintiff) conceded at oral argument, the relevant factual and legal circumstances of this case were indistinguishable from Fernandez, so, as noted by the Court, the Court’s real objective in this appeal was to determine whether the court of appeals’ ruling on a matter of federal law was wrongly decided in such a way that the Court would deem it to be without logic and reason. (For a more detailed discussion of Fernandez, see “Biometric Information Privacy Act and Collective Bargaining Agreements” available at https://bit.ly/BIPA_Collective_Bargining_Agmts_MIB_202109.)
In addressing the issues raised by the certified question, the Court reasoned:
In contrast to finding the court of appeals’ decision to be without logic or reason (see State Bank of Cherry, 2013 IL 113836, ¶ 54), we think it is the proper interpretation of the Privacy Act when viewed through the prism of the Labor Management Relations Act’s preemptive effect. The Privacy Act contemplates the role of a collective bargaining unit that may act as an intermediary on issues concerning the employee’s biometric information. See 740 ILCS 14/15(b) (West 2020). The Privacy Act provides that “[n]o private entity may collect *** a person’s *** biometric identifier or biometric information, unless it first: (1) informs the subject or the subject’s legally authorized representative in writing that a biometric identifier or biometric information is being collected or stored; (2) informs the subject or the subject’s legally authorized representative in writing of the specific purpose and length of term for which a biometric identifier or biometric information is being collected, stored, and used; and (3) receives a written release executed by the subject of the biometric identifier or biometric information or the subject’s legally authorized representative.” (Emphases added.) Id. Under the Privacy Act, it is clearly within a union’s purview to negotiate with the employer about its members’ biometric information. The grievances that Walton has raised against Roosevelt are all things that his union can bargain about, but his complaint raises the question of whether such bargaining has occurred, either implicitly or explicitly.
The collective bargaining agreement at issue in this case contains a broad management rights clause. The agreement makes the union the sole and exclusive bargaining agent for the employees in the union. Walton and any other similarly situated employees agreed to their employment being covered by the subject collective bargaining agreement. The timekeeping procedures for workers are a topic for negotiation that is clearly covered by the collective bargaining agreement and requires the interpretation or administration of the agreement. The members of the collective bargaining unit in this case have surrendered their individual right to bargain with their employer about timekeeping procedures, even where those timekeeping procedures also include the collection and use of the employees’ biometric information. …
Unions frequently bargain for matters concerning their members’ privacy and protection. Collective bargaining agreements may include express and implied terms (id.), and it is up to an arbitrator, not a state court, to define the scope of the parties’ agreement (Fernandez, 14 F.4th at 646-47).
In answering the certified question, the Illinois Court of Appeals held:
Walton and his fellow unionized employees are not prohibited from pursuing redress for a violation of their right to biometric privacy—they are simply required to pursue those rights through the grievance procedures in their collective bargaining agreement rather than in state court in the first instance. Walton cannot bypass his union, his sole and exclusive bargaining agent, to demand that Roosevelt deal with him directly on this issue. Walton comes to the court attempting to represent a class of similarly situated employees over a workplace grievance, but that is a place for his union, not Walton himself. Federal law prevents state courts from stepping in and usurping the bargained-for dispute resolution framework where the parties have elected to establish a working relationship that comes within the purview of the Labor Management Relations Act. Accordingly, we answer the certified question in the affirmative and find that Privacy Act claims asserted by bargaining unit employees covered by a collective bargaining agreement are preempted under federal law.
Conclusion
The bottom line is that employers using, or planning to use, biometric devices (e.g., timeclocks, facial recognition, etc.) in the workplace need to be aware of the biometric privacy legislation applicable to the jurisdictions where they do business and where their employees (and others interacting with those biometric devices) reside. In particular, employers subject to a Workers’ Compensation Act or collective bargaining agreement under the Labor Management Relations Act (29 U.S.C. § 185 (2018)) need to understand their compliance responsibilities in light of the employer’s use of biometric devices and the relationship to their employees’ rights, and the business’s liabilities (which can be significant under BIPA-type legislation).
Offices are open. Employees are coming back. But it won’t be an easy return. “Returning is going to pose one of the most complex financial-cultural-operational-technological-recruiting and retention-organizational challenges that law firms have faced in years,” one observer noted.[1] There is no one-size-fits-all answer, because firms’ rules will need to reflect the makeup of each firm. Key differences include:
Generational distribution within the workforce
Practice areas’ need to be together in the office
Individuals’ work assignments—e.g., drafting vs. brainstorming
Personal preferences
One of the most disruptive areas of change relates to the need to attract and retain talent. Living through the two-year pandemic aberration changed people’s minds about the importance of work, the place of work in their lives, the ability to work effectively from anywhere, and the importance of being valued and sharing values. Now they want their workplaces to change, too.
Law firm associates want to be treated as individuals and future leaders rather than as fungible worker bees putting in crazy long hours to meet billable hour requirements. Other non-equity lawyers want to be acknowledged for their skills instead of denigrated for their lack of interest in attaining equity status. Marketing and management staff no longer want to be relegated to a “non-lawyer” category (i.e., less important, less bright but necessary). All these understandable desires run up against traditional firm cultures, which:
measure and reward time instead of results,
believe that in-person collaboration and communication provide the only environment in which new lawyers can learn the art of lawyering, and
assume small leadership cohorts should make decisions for everyone without asking for or paying attention to the opinions of the rest of the firm.
Let’s look at some of the specific areas of disconnect and possible solutions.
Hybrid Office Rules That Maximize Individual Flexibility and Autonomy
Most employees do not want to return to the 2019 office. They want to continue the taste of choice they had when COVID-19 sent everyone home: the ability to work from anywhere and set their own work schedule and work hours. They remember the positives of remote work: time flexibility, better integration of work into their whole life, and an opportunity to focus on what’s important. They forget the negatives of burnout, loneliness, and inability to set work boundaries.
For firm leadership, two important elements emerge:
The need to structure work to maximize productivity and collaboration while addressing remote/in-office scheduling and the causes of burnout.
What kind of scheduling will meet the demand for flexible work time, the right to work away from the office, and the need for productive teams?
What kind of manager-employee communication creates a workplace that people want to be part of?
The need to respond to the emphasis on values—personally important and also important as part of firm culture.
How do you show that a person is valued?
How do you help them develop the skills needed to progress in a career?
Is the firm’s mission larger than just making more money for equity partners? How does it help improve the world?
A Framework for Hybrid Office Work
Schedules are essential as a framework for work. There needs to be some certainty as to where people are, when. At the same time, employers should assume nonlinear days and asynchronous work schedules are consequences of remote work options and flexible work schedules. According to a Future Forum survey, 76% of non-executive knowledge workers want flexibility in where they work and 93% want flexibility in when they work.[2]
Some possible ways to establish a modern framework that balances the competing needs:
Invest in modern technology and make sure that everyone has similar equipment for their home office.
Maximize use of technology that encourages and supports communication up, down, and sideways.
Require everyone to be in the office two to three days a week, or require teams and colleagues who work with them to set days when they are together in person.
Facilitate individual flexibility regarding when and where people work, balancing it with established times for collaboration.
Address personal burnout by setting “core hours” when everyone has to be online or offline. Make weekends email-free time. Expect people to have work-free weekends most of the time.
A Framework for Recognition
Few law firm associates spread tales of partner kindnesses. Rather, they complain about overwork and negative feedback. What they want is appreciation for what they do and a feeling of personal interest in them and their career from those they report to. Law firm leaders at all levels, from managing partner to team leader, need to learn to use emotional intelligence to understand their own hot buttons, control them, and listen to their subordinates with empathy and interest.
“The Future Forum puts it another way, advising executives to embrace flexibility, reward inclusion, and build connection through transparency─in other words, pay attention to what staff want and give it to them.”[3]
To address employee demands, law firm leaders and managers need to create training and development opportunities for everyone in the firm. Online training programs can supplement in-person opportunities to watch and learn. This changes the tone of the culture because when programs connect with individuals’ needs, they feel invested in, and this makes them feel happier about their work and their firm.
Some strategies to respond to employees’ requests for training, career planning, and values alignment:[4]
Include training in the firm culture and necessary soft skills as part of the onboarding process. In addition, pair each new hire with a peer-level mentor to support them as they learn the ropes.
Encourage “job crafting,” the process through which employees have input into their roles. It increases their motivation to succeed because it demonstrates that the firm is willing to invest in them.
“Agile firms” that can attract and keep talent will “redefine productivity to include ongoing learning, . . . and identify advancement opportunities for every employee.”
Leaders will encourage transparency. Rather than decree how it will be, they will discuss their ideas with the people who will be impacted by them and try to incorporate their feedback.
Invest too in leader training, especially for next-generation leaders. Actively look for nascent leaders among the rank and file, those informal leaders whom others follow.
Gen Z and millennial employees want to work for firms whose values align with theirs. To meet them halfway, firms should share their values and work with interested employees to implement them through concrete activities.
“The days of command and control management are gone. Employees are now in the driver’s seat. … [E]ncourage intentional listening (listening with intent to understand not the intent to respond) to find out what they [employees] want and need to be happy and successful.”
Concluding Thoughts
Of course, this discussion of remote work options, flexible work time, and robust, firmwide training avoids the elephant in the room─equating productivity to billable hours instead of to results. Other knowledge firms─accountants, consultants─set prices based on the value of their knowledge, rather than the time needed to produce results. As AI tools, apps, and programs become more common in law firms, the move away from billable hours as the basic revenue generator will move faster. To continue to make money, firms will have to transition to results-based measurements.
This article suggests new interactions between leaders and led, all designed to attract and retain talent, a necessary competitive advantage for any firm. The next article will focus on ways to restructure firms to support DEI─diversity, equity, and inclusion.
SPACs are running into choppy water these days. The Delaware Court of Chancery’s January 2022 opinion denying motions to dismiss in the MultiPlan Corp. litigation may be a significant source of concern for SPACs. Certainly, the case and Vice Chancellor Will’s 61-page opinion are of great interest to all in the SPAC community.
First and foremost, MultiPlan is the first time Delaware courts have applied fiduciary duty principles in the SPAC context. The courts’ decisions in this case could foretell its treatment of increasing numbers of SPACs that find themselves faced with lawsuits in Delaware court, a state where many SPACs are registered.
Second, the opinion touches on multiple topics, including conflicts of interest, disclosure, and the legal standard to be used for SPAC-related cases. Many law firms have put out excellent summaries and analyses of the case, including Skadden, DLA Piper, Mayer Brown, and Cooley.
Most articles analyzing this decision, however, do not discuss its directors and officers (D&O) insurance-related implications. From the insurance perspective, there are several interesting points to note.
Which SPAC D&O Insurance Policy Would Respond?
The first point of interest is which D&O insurance policy will be tapped to cover defense costs for the defendants. The defendants here, like in many other SPAC-related suits, are the SPAC (Churchill Capital Corp. III), the SPAC’s sponsor (managed by an entity wholly owned by Michael Klein, a serial SPACer), and the SPAC’s directors and officers, Klein among them.
The shareholder plaintiffs allege that defendants breached their fiduciary duty when they issued a false and misleading proxy statement. The plaintiffs allege that there should have been disclosure about the fact that MultiPlan’s largest customer was building an in-house platform to compete with MultiPlan. This lack of disclosure, according to the plaintiffs, impaired Class A stockholders’ informed exercise of their redemption and voting rights.
Even though the MultiPlan lawsuit was brought four months after the close of the business combination, the allegations relate to misstatements in the proxy statement that was filed prior to the business combination. Therefore, the policy that would respond on behalf of the SPAC and its directors and officers would be the D&O policy placed at the time of the SPAC IPO or to be more precise, its tail.
The tail is very important here. Remember that D&O insurance policies are “claims made” policies, meaning that the policy cannot have expired and must be active for it to respond to a claim. A “tail” is a reference to paying additional premium so that the policy stays open for claims past its natural expiration. In the case of SPACs, the initial IPO policy is typically an 18- or 24-month policy. These policies typically include pre-negotiated terms for a six-year tail. When the SPAC closes its business combination, it must ensure that the tail premium is paid as part of the closing of the business combination.
The concern is what happens if—as was exactly the case in MultiPlan—shareholders decide to sue the SPAC and its directors and officers after the deal closes. Here, the lawsuit was brought four months after the close of the business combination and the related “change of control” as that term is typically defined in D&O policies. Presumably in this case, as is typical, the SPAC purchased the SPAC IPO’s tail policy at the time business combination closed. As a result, one would expect the SPAC’s original D&O insurance policy to respond to the pending litigation on behalf of the SPAC and the SPAC’s directors and officers.
It’s worth noting that while the go-forward public company may have agreed to indemnify the SPAC and the SPAC’s directors and officers against future claims brought after the deal closed, the go-forward public company’s D&O insurance will almost always exclude coverage for these types of claims. This, in addition to the fact that the target’s purchasing of the tail is market practice, is a big reason why the go-forward public company is typically willing to provide the funds for the SPAC’s tail policy.
Unscrupulous Behavior by Certain Brokers
It is also worth noting that some unscrupulous D&O insurance brokers have started suggesting to SPACs that they should purchase their tail from new carriers instead of adhering to the pre-negotiated tail terms they agreed to at the time of the SPAC IPO. Unlike in a traditional M&A context, this practice is heavily frowned upon in the SPAC context. Recall that carriers who wrote the SPAC IPO policy did it with the expectation of their ultimate receipt of the full premium. The first portion of the SPAC D&O policy premium is paid at the time of the initial IPO, with the second portion paid when the business combination closes.
Indeed, to offset high upfront costs for working capital–poor SPACs, most carriers have historically agreed to under-charge at the time of the IPO because they understand that the tail will be purchased from them. SPAC directors and officers who choose to ignore this understanding may find it difficult, if not impossible, to get good terms for their next SPAC. Unsurprisingly, insurance carriers keep close track of which SPAC teams are “shopping” the tail.
D&O Insurance Carriers Are Concerned about Conflicts of Interest
Another MultiPlan case theme that insurance carriers are monitoring closely is the issue of conflicts of interest. Vice Chancellor Will discusses at length the conflicts of interest existing in this case among the SPAC, its CEO and Chairman Michael Klein, and his affiliate, The Klein Group LLC. The SPAC’s board selected The Klein Group LLC as its financial advisor and paid it $30.5 million in connection with the merger and its financing. These interrelations led Vice Chancellor Will to conclude that the less defendant-friendly “entire fairness standard” rather thanthe more common “business judgement rule” standard should be applied in this case. This determination essentially made winning a motion to dismiss impossible for the defendants.
Judge Will’s conclusions intersect with insurance carrier concerns in two different ways. One is that D&O insurance underwriters have become highly sensitive to potential conflicts of interest between SPAC teams, their sponsors, and directors on one hand; and public shareholders on the other. It is standard now for an insurance underwriter to ask multiple follow-up questions and request to see extensive disclosure around all potential conflicts of interest. If these questions and requests are not satisfied, and in some cases even if they are, many insurers are unwilling to offer coverage for claims arising out of transactions with affiliated entities of the SPAC or will only do so at elevated pricing.
Insurance carriers are also interested in the issue of whether claims in MultiPlan are direct or derivative. Direct cases are easier to bring because, unlike the derivative ones, they do not need to go through an extra step of satisfying demand futility requirements. In MultiPlan, Vice Chancellor Will decided that the claims are direct because “the plaintiffs are not suing because Churchill did not combine with MultiPlan on more favorable terms. They are suing because the defendants, purportedly for self-serving purposes, induced Class A stockholders to forgo the opportunity to convert their Churchill shares into a guaranteed $10.04 per share in favor of investing in” the combined entity.
From a D&O insurance perspective, there is a real consequence to the direct versus derivative distinction because of the way the insurance agreements work. The “Side A” part of the ABC D&O insurance program responds on a first-dollar basis, but only to non-indemnifiable claims. Settlements of derivative suits are usually not indemnifiable under Delaware corporate law, while direct suits are indemnifiable. While many SPAC D&O insurance programs are structured as traditional “ABC” programs, some SPAC teams, as a cost-saving alternative, are choosing to structure their programs as “Side A” only.
To the extent that a SPAC purchased a Side A–only policy, and the lawsuit is determined, like in MultiPlan, to be a direct one, there may be no D&O insurance response for a settlement (outside of a corporate bankruptcy).
For more about the various insurance agreements for a D&O insurance policy, you can refer to this article: Side A Insurance Overview for Directors & Officers. As a reminder, as long as a company is solvent, defense costs are always indemnifiable, which is to say not covered by a Side A–only D&O insurance program.
The Potential Effects of the Multiplan Case on the D&O Insurance Market
D&O insurance carriers, along with the rest of the SPAC market, are worried that cases like MultiPlan are easier to bring because they are direct and not derivative cases. If plaintiffs decide that this is a lucrative venue for them, litigation frequency will, of course, go up. If litigation frequency increases, SPACs will be more difficult to insure, and rates for D&O insurance for SPACs, which are already quite high, will surely rise.
Some have suggested that the MultiPlan litigation has prompted many SPAC teams to consider incorporating their SPACs outside of the United States, with the Cayman Islands being the preferred jurisdiction. The theory is that plaintiffs will be less successful in attempting lawsuits against Cayman-organized SPACs. This solution may create more problems than it may solve. Setting aside complex tax structuring and other difficulties, SPACs organized in the Cayman Islands will have a harder time securing D&O insurance because many US insurance carriers will not be able to offer D&O coverage for non-US entities.
An earlier version of this article appeared in the Woodruff Sawyer SPAC and D&O Notebooks on March 8, 2022.
The directive on cross-border conversions,[1] mergers and divisions that was adopted by the European Parliament and the Council (Directive (EU) 2019/2121) on November 27, 2019 (the “Directive”), will bring beneficial changes to the legal frameworks for European Union (EU) cross-border transactions but will also come along with lengthy and more stringent requirements compared to the status quo.
Under current legal regimes, cross-border conversions of companies are one of the simplest ways to move business activities from one to another EU Member State or abroad and should be considered by U.S. and non-U.S. multinationals in the context of cross-border group reorganizations and restructurings.
Germany, Luxembourg, the Netherlands, Italy and France are among the Members States that implement the majority of all cross-border corporate transactions including mergers, conversions and divisions at an EU level. Germany and Luxembourg, in particular, go strong, with Germany heading the overall number of transactions and Luxembourg ranking number one in implementing conversions within and outside of the EU, outnumbering by far all other Member States.[2]
Luxembourg is one of very few Members States that have codified provisions on cross-border conversions within and outside of the EU. Luxembourg’s long-established, widely tested and reliable practice adds legal certainty and predictability when it comes to implementing cross-border conversions or other operations. Member States with no such legal provisions may cross-border convert based on numerous court cases in which the European Court of Justice has confirmed the possibility for companies to cross-border convert between Member States on the basis of the freedom of establishment. However, the absence of codified rules, and the differing applications and interpretations of the principle of freedom of establishment on cross-border conversions throughout all Member States, leaves a level of uncertainty and unpredictability when it comes to implementation of cross-border operations which can result in a reorganization or restructuring being lengthier and costlier.
The Directive will bring significant change to the existing legal cross-border conversion framework.
Twelve questions and answers about the implementation of the Directive into national laws:
1. What are the aims of the Directive?
The Directive aims to create a common legal framework for cross-border conversions and divisions and to clarify the existing provisions on cross-border mergers within the EU.
While the laws of many Member States currently provide codified provisions for cross-border mergers of limited liability companies (e.g., the Netherlands in its Dutch Civil Code under Article 2:308 et seq., or Luxembourg in its Company Law under Article 1020-1 et seq.), those laws either completely lack or include only marginal codified provisions on cross-border conversions or cross-border divisions. Once implemented into national laws, the Directive will close this gap, enhancing legal certainty and harmonization of rules on cross-border conversions and divisions throughout the EU, in addition to strengthening the rights of shareholders, employees and creditors in EU cross-border operations.
2. Which types of companies benefit from the Directive?
The Directive has a limited scope. It covers limited liability companies, i.e., private limited liability companies such as a Luxembourg S.à r.l. (société a responsabilité limitée) or a Dutch B.V. (besloten vennootschap met beperkte aansprakelijkheid) and public limited liability companies such as a Luxembourg S.A. (société anonyme) or a Dutch N.V. (naamloze vennootschap). Those types of companies are outside of the scope of the Directive if they are subject to a liquidation, insolvency proceeding or preventive restructuring measure.[3]
The rationale behind the Directive’s limited scope is that limited liability companies are the most widely used company forms for cross-border operations in the EU. In addition, legal provisions on limited liability companies are sufficiently harmonized throughout the EU while this is not yet the case for other company forms.[4]
The currently applicable Luxembourg law goes beyond the Directive’s scope and permits cross-border conversions not only for limited liability companies but for all commercial companies as long as they have a legal personality, including partnerships limited by shares (SCA or société en commandite par actions) or the European company (SE or société européenne). It is to be seen how Member States will implement the Directive into national law, so its impact on the current scope of law in Luxembourg cannot be determined at this point.
3. What is the jurisdictional scope of the Directive?
The Directive covers cross-border conversions between Member States. Cross-border conversions from or to a jurisdiction outside of the EU are outside of the Directive’s scope and must be based on applicable national legislation and regimes.
Today, most Member States including Luxembourg already allow for cross-border conversions from and to countries that are not EU Member States, thereby providing easy access of foreign companies to the EU financial market, as well as exit strategies to leave it.
4. When do the new provisions kick in?
All Member States will need to implement the Directive into national law by January 31, 2023, at the latest.
As of the date of this article, to the best of our knowledge, no Member State has implemented the Directive into national law.
5. What is a cross-border conversion under the Directive?
A cross-border conversion is the conversion of the legal form of a company with legal personality in a departure Member State into another legal form in a destination Member State. The converting company does not dissolve, wind up or liquidate and retains its legal personality. It continues to own all its assets and hold all its liabilities post-conversion without interruption. All agreements that existed pre-conversion continue to exist post-conversion.
In addition to cross-border mergers, the Directive foresees cross-border divisions through the creation of one or more limited liability companies by means of (i) a split-up (i.e., a full division); (ii) a split-off (i.e., a partial division); and (iii) a transfer to a newly formed subsidiary (i.e., a division by separation). In the last case, it is the dividing company itself (rather than the shareholder(s) of the dividing company) that acquires shares in the acquiring company or companies.
6. How do the real seat theory and the incorporation theory affect a cross-border conversion?
In a cross-border conversion, a company’s registered office (or registered seat) must be transferred from the departure country to the destination country.
If the country of destination applies the “real seat theory,” the place of central administration or principal place of business must be transferred to the country of destination in addition to the registered office.
If the country of destination applies the “incorporation theory,” neither the central administration nor the principal place of establishment must be transferred to the country of destination.
7. What will the cross-border conversion procedure look like?
The cross-border conversion procedure is to a large extent a replication of the merger procedure provisions made available by the directive relating to certain aspects of company law (Directive (EU) 2017/1132) of the European Parliament and the Council of June 14, 2017.
The key steps and documents include:
Management conversion proposal published with a notice to stakeholders.
Management report to shareholders and employees explaining and justifying the legal and economic aspects of the conversion, and implications for future business.
Compliance with employee information, consultation and participation rights.
Independent expert report examining and reporting on draft conversion proposal.
At least one month after conversion proposal publication date, holding of general meeting of shareholders approving conversion. Majority requirements (i.e., between 2/3 and 90% of voting rights and equal to or lower than the merger majority requirements).
Pre-conversion certificate issuance certifying completion of conversion steps in departing Member State within three months. No issuance if conversion serves fraudulent, abusive or criminal purposes. Automatic transmission of certificate to destination Member State competent authority.
Destination Member State verification by competent authority of compliance with local law incorporation and registration rules.
8. Will waivers of the requirements to prepare certain documents be available?
Waivers are an option for some requirements, including for the preparation of a management report explaining and justifying the legal and economic aspects to shareholders and employees and of an independent expert report thereon.
9. How will cross-border conversion effectiveness be determined?
The destination Member States laws determine the date of effectiveness of the conversion between and toward third parties.
10. What kind of creditor, shareholder or employee protection is available?
Creditors may apply for adequate safeguards within three months of the date of publication of the draft conversion proposal, and creditors whose claims predate the publication of the draft conversion proposal may start proceedings in the departure Member State within two years of the effective date of the conversion.
Shareholders are protected by two means from becoming a shareholder in a foreign company resulting from a cross-border conversion (or a cross-border merger or division as regards the company ceasing to exist). One, shareholders can disapprove the cross-border conversion, and two, if they disapprove, shareholders have a right to exit the company by selling their shares and to receive cash compensation.
Employees will have advisory, retention and participation rights among others.
11. What are the advantages of the current applicable regime for cross-border conversions to and from Luxembourg?
Outbound cross-border conversions from Luxembourg to a Member State or non-EU Member State currently benefit from a short implementation period with minimal documentation required. Another key benefit of the current regime is that cross-border conversions are within the control of the shareholder(s) involved.
They key documents required from a Luxembourg legal perspective are shareholder approval resolutions to cross-border convert, to be taken in form of a notarial deed. Depending on the destination jurisdiction, supplementary documentation may be required, such as a legal opinion confirming permissibility of cross-border conversions with legal continuity of the personality and compliance with all applicable formalities.
The Luxembourg steps can usually be completed within one to two weeks. No waiting periods must be observed, and, apart from a Luxembourg notary public, no other competent authorities are involved in the process that could cause delay or make the completion of the Luxembourg steps more burdensome.
The steps to be taken in the destination country vary, but they usually also require the execution of shareholder(s) resolutions approving the cross-border conversion and can also typically be completed rather swiftly.
Inbound cross-border conversions from an EU or non-EU Member State to Luxembourg can be implemented within the same time frame and with the same requirements as outbound cross-border conversions, with the exception that the Luxembourg notary almost always requires a legal opinion confirming the laws of the departing jurisdiction permit cross-border conversion to the EU, as well as documentation confirming that the equity of the company to be converted is sufficient for Luxembourg legal purposes.
The steps to be taken in the departing country may vary but usually require the execution of shareholder(s) resolutions.
12. What are the pros and cons of the Directive?
On the one hand, the Directive enhances legal certainty by creating harmonized rules throughout the EU and stakeholder protection rights for employees, creditors and shareholders of limited liability companies, including a shareholder exit right in case of disapproval of a cross-border conversion. Other benefits of the Directive are that it provides for modernized rules throughout, and promotes legal mobility of companies within, the EU.
On the other hand, once implemented into national laws, cross-border conversions will, at an EU level, be more complex and time-consuming and less predictable, due to a significant increase in required documentation, the involvement of additional parties such as independent experts, and additional stakeholder rights that need to be factored in. Moreover, the process will be lengthier, with less planning predictability regarding the completion date, because of the inclusion of a one-month waiting period, and the involvement of public authorities for pre-conversion requirement verifications will be stricter than the currently applicable regime.
Disclaimer:
This article has been prepared for general informational purposes only and is not intended to be relied upon as accounting, legal, tax, or other professional advice. Please refer to your advisors for specific advice.
Depending on the jurisdictions involved, terminology varies throughout the EU Member States, and other commonly used references for cross-border conversions in the EU are “re-domiciliations” or “migrations.” ↑
Luxembourg company law permits companies subject to insolvency proceedings or in liquidation to carry out a cross-border merger or division, unless the allocation of their assets among their shareholders has already been initiated. No express provisions exist for cross-border conversions. ↑
Earn-outs are an often used and potentially effective mechanism to help bridge the price gap between buyers and sellers. However, there are a number of key considerations regarding earn-outs that, if not properly considered, can lead to suboptimal outcomes.
Problem
Oftentimes, although both buyer and seller are highly motivated, their respective expectations of future financial performance of the target can be meaningfully different, creating a substantial bid-ask spread in the acquisition price.
With both parties highly motivated to finalize the deal, they are eager for ways to bridge that gap. One useful tool in this regard is the “earn-out.” However, for the dealmakers to craft an effective earn-out, they need to understand certain mechanisms of the earn-out. These mechanisms can be:
structuring considerations;
dispute resolution;
valuation considerations; and
tax considerations, to name a few.
Without grasping these key considerations, the buyer or seller may wind up disadvantaged at the time of the deal or later, when it comes time to realize the earn-out.
Therefore, it is critically important for attorneys and their clients to think through these issues fully.
Solution
Houlihan Lokey, a leading valuation and investment banking firm, has built a wealth of experience in understanding and identifying some of these considerations.
We have prepared highlights of some of the key nuts and bolts of earn-outs. We hope this information will be useful in helping you and your clients think through the various issues that can accompany an earn-out structure.
Overview of Earn-Outs: An Abbreviated Summary
This section briefly summarizes the more in-depth information that follows. For more detailed discussion of these topics, see the next section, “Understanding Earn-Outs in Detail.”
An earn-out is a provision in an acquisition agreement that makes a portion of the purchase price payable to the seller if/when certain post-closing performance targets are achieved.
Bridges the Gap Between Buyer and Seller
Situations where the seller’s optimism contrasts with the buyer’s skepticism can often be found in businesses with:
limited operating history,
financial distress,
a historical pattern of not meeting budgets/forecasts,
an uncertain business environment with unusually high volatility (e.g., COVID-19), or
an unproven product or new market for an existing product.
Commonly Used
Earn-outs are found in nearly 30 percent of M&A deals, but are more typical in private deals with deal values under $250 million. An earn-out can mitigate risk for the buyer, while giving the seller an opportunity to enhance the aggregate consideration. A poorly structured earn-out can result in mismanagement of the newly acquired business and lead to post-deal disputes.
“[A]n earn-out…typically reflects [a] disagreement over the value of the business that is bridged when the seller trades the certainty of less cash at closing for the prospect of more cash over time…But since value is frequently debatable and the causes of underperformance equally so, an earn-out often converts today’s disagreement over price into tomorrow’s litigation over the outcome.”[1]
The challenge in crafting an earn-out is to reconcile the parties’ competing priorities and their desire to shift as much post-closing risk as possible to the other party.
Buyer Considerations
Could result in a higher purchase price if the acquired business proves successful
May result in restrictions in operating the newly acquired business
The chosen measure for the achievement of earn-out may be poorly defined and not ultimately as meaningful or relevant
Seller Considerations
Underperformance can lead to reduced purchase price
Postponing payment increases the risks of external impact adversely impacting the aggregate purchase price paid
Seller may surrender control to the buyer and/or be adversely impacted by the buyer’s business, making it more difficult to achieve the earn-out
Structuring Earn-Outs
Each earn-out is unique, but several provisions are usually addressed—and if not, post-deal disputes may ensue.
Key Provisions to Be Addressed
Defining the Business
Relevant Performance Metrics
Financial metrics (e.g., revenue, EBITDA, net income, etc.)
Thresholds
The required level of the financial metric
Milestones
Non-financial (e.g., FDA approval of a drug)
Measurement Standards
GAAP and/or exceptions to GAAP
Form of Consideration
Securities law issues
Earn-Out Period
Buyer/seller considerations with respect to the period
Sufficient to assess performance of the business
1–3 years is common
Operational Control
Critical Issue: buyer flexibility to run the business versus the seller’s desire to maximize the earn-out
Payout Formula
Binary
All or nothing; more common with milestones
Graduated (e.g., [x]% of adjusted EBITDA)
Multiple (e.g., milestone plus a revenue threshold)
Caps/floors
Maximum/minimum payouts under the earn-out
Payout schedules
One or several payouts
Indemnification
Offsets against amounts due to the buyer
Dispute Resolution
A large body of Delaware case law suggests that earn-outs tend to only postpone disputes because cases typically involve a business’s failure to meet earn-out criteria. Key considerations concerning earn-out-related disputes include payout calculation, arbitration vs. litigation, and breach of contract or breach of the implied covenant of good faith and fair dealing.
Delaware courts interpret earn-out provisions literally, and intent of the parties is paramount. Resorting to good-faith provisions can be problematic. Sellers may claim, among other things, that the payout calculation was incorrect or there were certain breaches by the buyer.
Payout Calculation Disputes
If the buyer and seller disagree initially on the payout calculation, the agreements typically would call for an expert or arbitrator (a “neutral”) to make a final determination. (An expert or arbitrator is an important distinction with significant consequences.)
Note, Delaware courts will not lightly intervene in payout calculation disputes, which may lead to pursuit of other legal actions. Therefore, it is important for the agreement to distinguish payout calculation and other causes of action, which would be resolved in a different manner.
Payout Calculation Considerations
Relevant concerns that should be addressed in the provisions regarding the payout provisions include:
how the neutral will be selected
the scope of review and whether the neutral will be an expert or arbitrator
who pays
whether the neutral will be bound by methodologies provided for in the agreement or can raise issues beyond those identified by the parties
the timetable
the basis for dispute of the neutral’s conclusion
Agreements sometimes include mandatory arbitration as the primary means of dispute resolution. However, litigation may arise over whether a court or an arbitrator has jurisdiction to make certain determinations.
Arbitration vs. Litigation
Some advantages of arbitration include speed, cost-effectiveness, and enhanced confidentiality. However, some advantages of litigation may include discovery, definitive resolution, availability of appeal, and alleviation of concerns over arbitrator competency or seeking a compromise value.
Breach of Contract
Losing sellers sometimes recast claims in a subsequent lawsuit alleging breach or express or implied obligations. This is a high bar. Delaware recognizes an implied covenant of good faith and fair dealing, which serves as a gap-filling role. Sellers will argue that the buyer may not undermine the business and that the implied covenant might obligate the buyer to take reasonable measures to achieve the earn-out. Buyers argue that there are no gaps to fill and that the implied covenant does not provide protections not secured at the time of the original agreement.
Valuation of Earn-Outs
There are a number of considerations for how an earn-out is treated for accounting purposes, and there are multiple ways to value the earn-out.
Accounting Treatment
An earn-out is treated as a liability if payment involves cash or variable number of shares. The liability must be remeasured to fair value at each reporting period until contingency is extinguished and associated change is recorded as a gain or loss on the income statement. If opening liability is greater than the payout, a loss is recorded, or vice versa. If payment involves a fixed number of shares, it is treated as equity.
How an earn-out is treated can impact the buyer’s income statement (e.g., EBITDA) and, thereby, may have an impact on certain other aspects of its business (e.g., bank financial covenant measurements).
Earn-OutMethodologies
There are two different valuation methodologies: the scenario-based method (SBM) and the option pricing method (OPM). In the SBM, multiple scenarios are identified. A payout is calculated for and a probability assigned to each, and an averaged payout is discounted at a risk-adjusted discount rate.
The OPM is better suited for non-linear payout structures or when multiple metrics involved. It treats earn-outs like a call option and employs option pricing models (e.g., Black-Scholes).
Tax Issues
The parties may have adverse tax interests in the characterization of payouts, so the treatment of the earn-out should be addressed as early as possible.
Tax Considerations for Parties
Compensation or purchase consideration
Compensation taxed as ordinary income to the seller, with a deduction for the buyer
Consideration taxed as capital gain to the seller, and the cost is capitalized for the buyer
Magnitude of payout
Should any tax sharing agreements be factored in as part of achieving thresholds?
IRS Considerations
Is the seller required to provide services to be eligible for payout?
Is the seller otherwise adequately compensated for services?
Are payouts proportionate to seller’s equity?
Do total payouts represent a reasonable price paid to seller?
What is the compensation of non-selling carryover employees?
How is the earn-out treated for tax and financial reporting purposes?
Contingent Value Rights
Contingent Value Rights (CVRs) represent a version of the earn-out in transactions involving publicly traded companies, and they are particularly common in the pharma-life sciences sector.
Tax Considerations for Parties
Typically, shorter in duration than traditional earn-outs and tied to an objectively verifiable outcome (e.g., FDA approval of a new drug).
Can be considered a security, subjecting it to registration requirements of the Securities Act
Five Factors
The SEC sets out five essential factors for CVRs not to be considered a security:
Integral part of transaction
Not represented by any form of certificate or instrument
No rights common to stockholders (e.g., voting) and does not bear a stated interest rate
Does not represent an equity or ownership interest
Not transferable
Understanding Earn-Outs in Detail
What Is an Earn-Out?
An earn-out is a provision in an acquisition agreement (the agreement) that makes a portion of the purchase price for a target company or business (the business) payable to the seller of the business (the seller) based on the post-closing performance of the business.
Earn-outs most often are found in private company acquisitions with a value of under $250 million.[2]The size of an earn-out relative to the total consideration in the transaction will typically reflect the magnitude of the disagreement between the parties with respect to the value of the business. An earn-out representing less than 15 percent of the purchase price may not be worth the time and effort to negotiate the earn-out provisions and/or the risk of future litigation.[3]
Payments of deferred purchase price and post-closing purchase price adjustments are not earn-outs.
A purchase price deferral is effectively a loan by the seller of a portion of the purchase price to the buyer of the business (the buyer).
Purchase price adjustments reflect changes in the working capital of the business between the signing of the agreement and closing and can increase or decrease the purchase price for the business, whereas earn-outs will only increase the purchase price in the future.
An earn-out in the context of a public company acquisition is known as a “contingent value right.” See the “Contingent Value Rights” section later in this article for more information.
When to Use an Earn-Out
Earn-outs can potentially bridge a gap between parties with differing views as to the business’s prospects and/or value.
An ex post “true-up” allows the parties to agree to disagree and complete the acquisition of the business (the acquisition).
Among other things, earn-outs may be particularly useful in situations involving a(n):
Business with a limited operating history but with significant growth potential,
Uncertain economic environment or a highly volatile industry,
Business with a historical inability to achieve its projections,
Unproven product or a new market for an existing product,
Business having recently undergone a financial or operational restructuring,
Company that has experienced a recent drop in earnings that may be temporary (e.g., due to COVID-19),
Business that is dependent on relatively few customers, or
Buyer with limited access to debt financing.
Properly structured, an earn-out can produce a win-win situation for both seller and buyer.
Advantages of an Earn-Out to the Buyer
Earn-out payments can be used to secure the seller’s indemnification obligations under an agreement. They provide the potential for greater aggregate consideration than in a fixed price structure (especially for the seller of a financially distressed business). And earn-out payments may allow the seller to benefit from synergies achieved by integrating the business with the buyer, allow for deferral of taxes (see the “Tax Issues” section for further discussion), and may allow the seller to control its own destiny if the incumbent management manages the business post closing.
Considerations Regarding Earn-Outs
A poorly crafted earn-out can result in mismanagement of the business and can create contentious post-deal disputes. As Vice Chancellor Laster of the Delaware Chancery Court (the Court) observed in Airborne Health:[4]
“[A]n earn-out…typically reflects [a] disagreement over the value of the business that is bridged when the seller trades the certainty of less cash at closing for the prospect of more cash over time…But since value is frequently debatable and the causes of underperformance equally so, an earn-out often converts today’s disagreement over price into tomorrow’s litigation over the outcome.”
The challenge in crafting an earn-out is to reconcile the parties’ competing priorities and their desire to shift as much post-closing risk as possible to the other party.
Buyers will want to (i) control the post-closing activities of the business and (ii) minimize the future earn-out payments. Sellers will want the buyer to (i) actively pursue the growth of the business and (ii) maximize the future earn-out payments. Structuring an earn-out usually involves complex accounting, valuation, and tax issues that require the involvement of expert advisors. Because it is impossible to anticipate and address every scenario that could impact the earn-out, there is usually a “trust-me” aspect to the negotiation.
Buyer Considerations
If the acquisition is successful, the buyer may pay more for the business than if it had paid a higher price up front.
An earn-out may impose restrictions and covenants on the buyer, including restrictions on integrating the business.
The seller may benefit from enhancements to the business contributed by the buyer after closing.
Due to unexpected changes, the chosen measure of success at closing may not be a relevant metric in the future.
If incumbent management continues to operate the business, short-term, earn-out targets may undermine the buyer’s long-term goals.
Seller Considerations
If the business underperforms, the seller will receive less consideration than anticipated.
The seller may lose the ability to influence decisions that affect the achievement of the full earn-out.
The business may be affected by exogenous post-closing factors that were not anticipated when the agreement was signed.
The buyer may not be motivated to improve the performance of the business during the pendency of the earn-out period.
Financial support from the buyer may be critical to achieving the business’s projections.
The seller is likely to lose custody of the books and records of the business (see Windy City).
The seller is vulnerable to the credit risk of the buyer.
Structuring Earn-Outs
Earn-outs are bespoke provisions; however, several key areas are typically addressed:
definition of the business on which the earn-out will be based,
relevant performance metric(s),
appropriate target(s) for achieving the earn-out,
amount to be paid if the earn-out target(s) are achieved (the payout),
appropriate standard for measuring the performance of the business (the performance metric),
formula that will quantify the payout,
appropriate time period for achieving the earn-out (the earn-out period),
allocation of post-closing control of the business, and
mechanisms for dispute resolution.
Defining the Business
If operated ex post as a subsidiary or segregated division, measuring the business’s performance should be relatively straightforward. Integration of the business with the buyer can make a pre- and post-comparison of performance of the business difficult.
The following matters, among others, should be considered in defining the business:
the specific line(s) of business to be included (by business line, customer type, price point, or region, etc.) (See Windy City);
whether expansion of the business by the buyer will count toward the earn-out (see Glidepath and Western Standard); and
the treatment of revenue from pre-closing customers common to the business and the buyer.
Performance Metrics
The performance metrics can be (i) financial, (ii) non-financial, or (iii) a combination of both.
Financial Performance Metrics
Financial performance metrics include income statement line items (for example, net revenues, EBITDA, net income), balance sheet items (e.g., net equity), or other performance metrics (such as buyer’s stock price).
Sellers prefer revenue-based performance metrics, which are less impacted by expenses and buyer post-closing accounting practices.
Buyers, on the other hand, prefer income performance metrics, as they can be better indicators of the success of the business. Buyers are more likely to insist on net income if incumbent management will operate the business post closing (to incent cost control).
Earnings before interest, taxes, and depreciation and amortization (EBITDA) is a commonly used financial performance metric. Because the aggregate purchase price is often calculated as a multiple of EBITDA, it is logical to use the same measure for the earn-out.[5] EBITDA is not defined under generally accepted accounting principles (GAAP) and may not be presented in the historical financials of the business. Accordingly, the items to be included/excluded in calculating EBITDA need to be clearly specified in the agreement.
Thresholds
The earn-out threshold (the threshold) is the financial performance metric level that the business must achieve for the seller to receive a payout. Thresholds are typically based on the seller’s projections for the business (the projections). Thresholds should be objective and measurable, plainly defined, and consistent with the character of the business.
Milestones
Non-financial performance metrics commonly include regulatory approval or the launch of a new product (a milestone and, together with a threshold, a target). Milestones obviate many of the complexities associated with structuring financial thresholds. However, an issue can arise as to whether a milestone can be achieved in part, but not in whole, (e.g., if only some of the claims of a patent are granted (see Gilead Sciences and Allergan)).
Milestones are especially useful in the context of emerging companies, where setting financial thresholds may be challenging due to the high growth trajectory of the business and/or the lack of historical information to use as a baseline. Milestones are most frequently observed in life sciences (FDA approval of a drug) and in technology (receipt of a patent).
A milestone structure requires the parties to agree on:
the specific milestone (see Gilead Sciences),
the specified degree of buyer efforts to cause, or to cooperate in causing, the milestone event to occur (see Allergan), and
any deadline by which the milestone must occur (see Shire).
The most successful milestone is either an event over which neither the buyer nor the seller has any control or an event that is so important, the buyer remains motivated to see that event occur, despite the obligation to make the milestone payout.
The parties should be very specific as to what types of approval satisfies a milestone. The use of industry and colloquial terms in defining the milestone (on the assumption everyone knows what is meant) can lead to subsequent disputes (see Valeant). Examples should be included in the agreement of what will, and what will not, satisfy the milestone (see Shire and Tutor Perini II). Parties should also ensure that documents outside the agreement, such as term sheets and board presentations, clearly and consistently describe any milestones.
Measurement Standards
Earn-outs based on financial performance metrics require that the post-closing financial statements allow the performance of the business to be accurately compared to the relevant threshold.
The seller’s goal will be to ensure that the earn-out calculation provides an “apples-to-apples” comparison between the pre-closing and post-closing performance of the business. The baseline methodology is usually GAAP, applied consistently with the seller’s pre-closing practices.
Reference to GAAP alone, however, is insufficient, as GAAP permits a wide range of accounting policies (see Chambers).
Some of the accounting issues that are commonly prone to dispute include, among others:
inventory valuation: excess and obsolescence reserves (see Winshall I);
collectability of accounts receivable and bad debt allowances (see Tutor Perini II);
current expense versus capitalization (see Chambers);
reserves for warranty and product returns and for pension and post-retirement benefits;
contingencies such as litigation and environmental clean-up; and
changes to conform to newly promulgated GAAP.
The parties and their advisors need to identify and agree on line items that will be a supplement (or an exception) to GAAP. Adjustments specified in the agreement take precedence over GAAP (see Chambers and LaPoint). The agreement should set forth in detail how the financial performance metric should be calculated, including how specific line items would impact the calculation. Illustrative calculations can be helpful in resolving later disputes (see Tutor Perini I). In particular, matters commonly addressed in determining a financial performance metric include, among others:
costs and expenses incurred in connection with the acquisition (see Chambers and Comet Systems);
allocation of intercompany overhead for home office services;
determination of appropriate transfer pricing in intercompany transactions;
treatment of extraordinary or non-recurring items of gain or loss (see Comet Systems);
revenues and expenses from new lines of business not contemplated by the agreement;
capital expenditures and R&D costs, the benefit of which accrue after the earn-out;
management or other fees charged to the business;
the treatment of discontinued operations; and
the treatment of synergies arising from the acquisition.
Payout Formula
Once the performance metric(s), threshold(s), and measurement standards are established, the parties need to agree on whether the payout will be structured as a fixed percentage of an underlying performance metric or as a complex, nonlinear function of the underlying performance metric, which can feature floors, caps, and catch-up or make-whole provisions (the payout formula).
Binary Payout Formulas
Under a binary or an “all-or-nothing” payout formula, a lump sum is payable only upon the achievement of a stated target (e.g., $10 million upon the launch of Product X). Binary payout formulas are more commonly found in earn-outs with non-financial milestones, such as regulatory approvals. A binary payout formula can incentivize the buyer or an incumbent management to take actions to miss or achieve the threshold, as the case may be. A binary payout formula can demotivate an incumbent management when it becomes apparent that the business will not be able to achieve a required target.
Graduated Payout Formulas
Given the negative incentives of a binary payout formula, sellers will try to negotiate a payout formula that is a percentage of the performance threshold (e.g., “the annual payout shall equal 5 percent of adjusted EBITDA” or a graduated payout formula). Graduated payout formulas are relatively uncommon, as buyers resist paying for performance that does not achieve the relevant target.
The compromise is to set a minimum threshold (e.g., “the payout shall be 15 percent of the excess of 2021 EBITDA over $5 million”).
Multiple Payout Formulas
Payout formulas can include more than one performance metric (e.g., satisfaction of two of the following: (i) a revenue threshold, (ii) an EBITDA threshold, and/or (iii) retention of X% of the business’s customers).
Multiple performance metrics reduce the opportunity for a buyer or an incumbent management to manipulate the earn-out.
Caps and Floors
The payout in an earn-out can become substantial if the achieved performance metric exceeds the threshold by a significant amount. Buyers will want to cap the amount of each payout or the aggregate of all payouts (see Tutor Perini and Windy City). Sellers will try to resist any caps and will try to negotiate for a minimum floor payout (see Windy City).
Including floors and caps narrows the range of potential discrepancy that can be subject to subsequent dispute.
Payout Schedule
Payouts may be in one payment at the end of a short earn-out period or in periodic installments over a longer earn-out period. Multiple installment payouts raise a number of complicated issues:
The buyer may want to set near-term payouts at a lower percentage than later ones to protect against future shortfalls but, conversely, may want to decrease the payout over time to reflect any synergies from integrating the business with the buyer.
If the business fails to achieve the threshold in one period but exceeds it in the following period, the buyer may require that the seller make up the prior deficiency before becoming entitled to receive the current year payout.
Similarly, if the business achieves the threshold in an earlier period but fails to achieve it in later periods, the buyer may seek to “claw back” all or a portion of the prior year payout.
Conversely, the seller will want to be able to make up any deficiencies in performance in one period with any excess in a prior or later period to achieve the target for the deficient period (see Tutor Perini).
Such complexities can be avoided through the use of a cumulative approach, which depends on the extent to which the average results during the earn-out period exceed a specified cumulative threshold.
Interaction with Indemnification
The agreement should specify any interaction between the seller’s indemnification obligations and the earn-out provisions. Buyers will want the right to offset payouts against amounts due pursuant to the seller’s indemnity under the agreement.[6]Buyers will resist having the earn-out be the sole source of indemnity payment inasmuch as the earn-out may never be earned. Sellers will want to ensure that a given event does not give rise to both an earn-out offset and a separate indemnity claim.
Form of Consideration
Payouts may take the form of cash or non-cash consideration, such as a buyer note or stock, or both. If the consideration is cash or a buyer note, the seller will assume the buyer’s credit risk and will want assurances that the buyer will be able to make required payouts when due, and they may request security in the form of an escrow.
Sellers will want to ensure that the buyer’s credit facilities (existing and, if possible, future) will not impact the buyer’s ability to make the required payouts when due. The seller may ask for interest to begin accruing at a punitive rate if the buyer does not make a required payout when due.
If payouts are to be made in buyer stock, the agreement will need to address a number of issues pertaining to:
the date as of which the value of the buyer stock will be measured (e.g., the closing or issue date),
the seller’s registration rights, if any,
any voting restrictions/requirements,
tag-along/drag-along rights,
repurchase right by the buyer,
restrictions on transferability, and
anti-dilution protection.
If the buyer is a private company, the parties will need to specify a valuation methodology (e.g., formula or third-party valuation). The seller will want to ensure that the maximum number of potentially issuable shares of buyer stock are reserved at closing and any required stockholder approvals are secured.
Securities Law Issues
The Securities Exchange Commission (SEC) has issued numerous no-action letters on the subject of whether an earn-out is a security and considers many factors when making this determination, including whether:
the earn-out is an integral part of the consideration to be received in the acquisition;
the earn-out right is represented by any form of certificate or instrument;
the holders of the earn-out have rights in common with stockholders (for example, voting and dividend rights);
the earn-out represents an equity or ownership interest in the buyer; and
the earn-out is transferable.
The Earn-Out Period
Once the appropriate performance metrics, targets, and payout formulas have been agreed upon, the parties will need to consider the length of the earn-out period, the end of which may be triggered by the passage of time or the occurrence of an agreed-upon event. The earn-out period should be sufficient to adequately assess the performance of the business. An earn-out period that is too short carries the risk that performance of the business may be distorted by temporary short-term factors, such as COVID-19 or a drop in the price of oil. An earn-out period of one to three years after closing is common.[7]
Buyer Considerations
Buyers prefer shorter earn-out periods to minimize the duration of any restrictions on their management of the business. The buyer may want an early buyout option in the event the earn-out hinders the buyer’s ability to operate the business. Ideally, the price of any buyout should be a fixed dollar amount to avoid interim payout calculation disputes. However, if incumbent management is to manage the business, an earn-out period that is too short might provide an incentive to sacrifice the buyer’s long-term interests for short-term profits. If financing is an issue, the buyer may prefer a longer earn-out period to have more time to actually make the required payout.
Seller Considerations
A shorter earn-out period can result in an earlier potential payout.
If incumbent management is running the business post closing, a longer earn-out period will provide more time to achieve the relevant target; however, a longer earn-out period reduces the present value of the consideration ultimately received. Sellers will want to include a provision that accelerates the payout upon the occurrence of certain events that might negatively impact the ability of the business to achieve its target, including, among other things:
a sale of all or a substantial portion of the business,
a default under any of the buyer’s credit facilities or other material contracts, and
termination of incumbent management for any reason.
Operating Control Issues
Two of the most difficult, albeit most important, aspects of structuring an earn-out are determining:
the degree of control (if any) that the seller will have over the business post closing, and
the level of support (if any) that the buyer will be obligated to provide to the business.
Balancing the buyer’s desire to run the business as it sees fit and the seller’s desire to protect the business’s ability to achieve its target(s) can be difficult and often leads to disputes.
Buyer Considerations
The buyer will want to negotiate for:
the right to operate the business in its sole discretion[9] (see LaPoint) and
a disclaimer of fiduciary duty to the seller regarding the earn-out.[10]
If the business is to be run by an incumbent management, the buyer will want covenants and restrictions in the agreement to ensure the business is not operated solely to maximize the payout through risk-taking or failure to invest. An incumbent management may face potential fiduciary duty conflicts. As employees of the buyer, incumbent management will have an obligation to do what is best for the parent corporation, even if that means taking actions that could adversely affect the business and reduce the likelihood of receiving a payout.
Seller Considerations
Sellers will seek to impose certain restrictions on a buyer’s operation of the business, including obligations for the buyer to:
operate the business consistent with past practice,[12]
use “commercially reasonable” efforts to achieve a target (see Allergan),
not take any action with the intent of decreasing the amount of any payouts,
provide the business with appropriate levels of working capital and capital expenditures,
maintain the existing research and development programs, and
not divert business to other entities controlled by the buyer.
The seller will also try to reserve some authority regarding major decisions by the buyer, including restrictions on:
disposing of all or a significant portion of the business,
hiring or firing of incumbent management,
restrictions on dividends from the business,
incurrence of additional debt, and
combining all or a significant part of the businesses with another company or business.
Dispute Resolution
Unfortunately, as observed by Vice Chancellor Laster in Airborne Health, earn-outs often merely postpone disputes, as is evidenced by the large body of Delaware case law respecting earn-outs. Though fact-specific, the cases usually involve a failure of the business to meet its target, followed by the seller’s claim the:
payout calculation was incorrect,
buyer breached the agreement, and/or
buyer breached the implied covenant of good faith and fair dealing (the implied covenant).
As with other contract provisions, when Delaware courts interpret earn-out provisions, the intent of the parties is paramount. An agreement’s plain language will be enforced notwithstanding a windfall to one of the parties (see Chambers and LaPoint). If the agreement is unambiguous, extrinsic evidence as to the intent of the parties will not be admissible (see Exelon Generation).
Ambiguous provisions are likely to result in a trial (see Stora Enso, Western Standard, and Windy City). The Court is unlikely to aid a sophisticated party that could have, but failed to, negotiate contractual protections (see Airborne Health). Recognizing the futility of trying to provide for every contingency, parties often resort to good-faith provisions in the agreement (usually at the seller’s request). The Court has criticized such provisions as “gossamer definitions” and “aspirational statements” that are “too fragile to prevent the parties from devolving into…dispute” (see LaPoint).
Payout Calculation Disputes
In the typical scenario, the buyer’s accountants prepare the post-closing financial statements and calculate the payout amount. The seller then has a period of time either to submit a notice of disagreement or to accept the calculation as final and binding. The buyer will often try to limit the seller’s scope of objections to factual or numerical mistakes, or inconsistencies with the agreement.
Failing a negotiated resolution of any disputes, the agreement frequently provides for the parties to jointly select an accountant from a third independent accounting firm (a neutral accountant), whose determination will be final. Whether a chosen neutral accountant is denominated as an expert or as an arbitrator can have serious ramifications. See Chicago Bridge & Iron Co. N.V. v. Westinghouse Elec. Co. LLC, 166 A.3rd 912 (Del. 2017) (Chicago Bridge). An expert determination is merely a determination of a specific factual issue that the agreement requires to be determined by an expert.
In contrast, an arbitrator’s powers are analogous to those of a judge and include, among other things, the power to interpret contracts, resolve factual disputes, determine liability, and award damages. An arbitrator’s award is enforceable by a court, with limited right to appeal or review under the Federal Arbitration Act (FAA).
Delaware courts will not lightly intervene in disputes over payout calculations when the agreement provides for arbitration and is likely to treat a neutral accountant’s resolution as final. The Delaware Supreme Court (DSC) has held that the courts have no role in considering disputes where the “plain language of the…agreement” made arbitration by [a neutral accountant]…the “mandatory path” for resolving disputes over a post-closing adjustment. (See Chicago Bridge. See also MarkDutchCo.)
There are important differences between a payout calculation (addressed by the neutral accountant) and potential causes of action, such as fraud or a breach of the agreement, which are not suitable for expert determination. The agreement should carefully distinguish and separate payout calculation disputes from such other potential issues. Relevant concerns in drafting a payout calculation dispute provision will include:
how the neutral accountant will be selected,
the scope of review by the neutral accountant (solely the payout calculation as an expert or “any and all disputes” as an arbitrator),
who will pay for the neutral accountant (the loser, or shared equally or proportionally) (see MarkDutchCo),
whether the neutral accountant is bound by the methodologies provided in the agreement,
whether the neutral accountant can raise issues beyond those identified by the parties (see Chicago Bridge),
what work papers will be provided in support of the neutral accountant’s calculation,
whether the neutral accountant is free to perform a de novo calculation to derive its own result,
a timetable for the process, and
the basis on which, if any, a party can bring a claim to dispute the neutral accountant’s determination.
The neutral accountant’s engagement letter is important because the scope of its mandate can be opened up beyond what was contemplated in the agreement if the parties agree to a wider scope in the engagement letter.
General Arbitration vs. Litigation
Agreements sometimes include mandatory arbitration as the primary means of dispute resolution. Factors favoring arbitration over litigation include speed, reduced expense, and enhanced confidentiality. On the other hand, factors favoring litigation include more expansive discovery, definitive resolution of legal issues, the availability of plenary appeal, concern over the competence of the arbitrator pool, and concern that an arbitrator will gravitate toward compromise outcomes.
Litigation can arise over whether a court or an arbitrator has jurisdiction to make certain determinations. The DSC has stated that:
“Issues of substantive arbitrability are gateway questions relating to the scope of an arbitration provision and its applicability to a given dispute, and are presumptively decided by the [C]ourt. Procedural arbitrability issues concern whether the parties have complied with the terms of an arbitration provision and are presumptively handled by arbitrators. These issues include whether prerequisites such as time limits, notice, laches, estoppel, and other conditions precedent to an obligation to arbitrate have been met, as well as allegations of waiver, delay, or a like defense to arbitrability.” (See Winshall I)
Once jurisdiction has been resolved, a Delaware court will likely take an expansive view of the competence of an arbitrator to decide a broad range of matters, including procedural questions as well as interpretation of the agreement and applicable law. Many of the same considerations apply to the appointment of a general arbitrator as pertain to the retention of a neutral accountant. If the agreement allows recourse to litigation, jurisdiction and venue should be clearly specified.
Breach of Contract
Losing sellers in payout calculation disputes often try to recast their claims in a subsequent lawsuit alleging that the failure of the business to achieve a target was due to the buyer’s breach of an express or implied obligation under the agreement.
Sellers (as the usual plaintiff in these cases) face an uphill battle in proving not only the buyer’s misconduct but also that such misconduct caused the business to miss its target. (See LPL Holdings and En Pointe.) The high bar results in many earn-out cases being dismissed at the motion to dismiss or summary judgment stage.
Delaware courts often hold that the buyer’s conduct reflected the exercise of legitimate business judgment and that the seller’s complaint is merely a dispute over business strategy. (See Lazard Technology, Boston Scientific, and Glidepath.) However, a claim based on the manner in which the business was operated post closing may involve factual determinations that will preclude a successful motion to dismiss. (See Edinburgh Holdings and Cephalon.)
Proving whether the seller has been damaged—and in what amount—requires expert testimony, especially when the business is a startup or has a limited track record, which makes it difficult to quantify how the buyer’s actions or inactions harmed the business. It can be difficult to prove that targets would have been reached but for breaches by the buyer, and the Court may be reluctant to speculate what the payout would have been in the absence of the breach. (See LaPoint and LPL Holdings.) The seller might consider seeking to specify remedies for breaches of any of the obligations or restrictions regarding the post-closing operation of the business—such as liquidated damages or payment of the maximum payout.
Breach of the Implied Covenant
Delaware recognizes an implied covenant that “requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain.” (See Winshall II.) The implied covenant serves a gap-filling function where the parties to the agreement did not anticipate some contingency, and had they thought of it, the parties would have agreed at the time of contracting to address that contingency. (See LPL Holdings.)
Sellers will argue that a buyer may not undermine the business and thereby deprive the seller of its “fruits of the bargain,” i.e., a payout. Sellers often further argue that the implied covenant obligates the buyer to take “reasonable” or even “best efforts” to reach a target.
The Court has held that the implied covenant does not impose a duty on a buyer to maximize an earn-out and does not “give the plaintiffs contractual protections that ‘they failed to secure for themselves at the bargaining table.’” (See En Pointe and Winshall II.) On the other hand, the Court is not tolerant of actions by a buyer that demonstrate an attempt to divert resources, opportunities, or revenue away from the business to avoid paying an earn-out. (See LPL Holdings and Haney.) Buyers defend against implied covenant attacks by emphasizing that the implied covenant is inapplicable when “the subject at issue is expressly covered by the contract.” (See Airborne Health, Lazard Technology, and Dialog Semiconductor.)
However, the Court has sometimes recognized claims for breach of the implied covenant where “the contracting parties would have agreed to proscribe the act later complained of…had they thought to negotiate with respect to that matter.” (See Winshall I.) The Court will not countenance a claim for breach of the implied covenant if such claim is duplicative of a related breach of contract claim. (See Edinburgh Holdings.)
Valuation of Earn-Outs
Accounting Standards
Under FASB ASC Topic 805 (Topic 805), the fair value of an earn-out is required to be recorded as a liability (the opening liability) on the buyer’s balance sheet if the payout involves the payment of cash or the issuance of a variable number of shares of buyer common stock. If the payout is in a fixed number of shares, it is classified as equity.
An earn-out recognized as a liability must be remeasured to fair value at each reporting period until the contingency is extinguished. To the extent there is a change in fair value, the change must be recognized as gain or loss on the buyer’s income statement. Contingent consideration recorded in equity is not required to be remeasured.
The accounting treatment for an earn-out is somewhat counterintuitive. If the opening liability is less than the payout, a loss is recorded (though the business is actually performing better than expected). On the other hand, if the opening liability is higher than the payout, a gain is recorded (though the business is not performing up to expectations).
The accounting for earn-outs can distort or skew a buyer’s EBITDA. If the business performs better than expected, the buyer may be required to book a loss, thereby reducing its EBITDA. The parties will also need to determine if and how such gains and losses figure into the payout calculation. A buyer also needs to address whether these types of gains and losses should be excluded in calculating leverage ratios in its credit and other material agreements.
Valuation Methods
In an effort to standardize the methodologies being used to value contingent consideration, in February 2019, the Appraisal Institute issued its “Valuation Advisory #4: Valuation of Contingent Consideration” (the Advisory), which suggested two primary methodologies for valuing earn-outs: the scenario-based method and the option pricing method.
Scenario-Based Method (SBM)
Under the SBM, multiple possible scenarios are identified for the underlying performance metric. A payout, if any, is calculated for each scenario and is weighted with an estimated probability factor. The weighted average payout calculated from the scenarios is then discounted to present value using a risk-adjusted discount rate. The choice of discount rate for the SBM should reflect the riskiness of the underlying performance metric.
Although the industry-weighted average cost of capital (WACC) is a reasonable starting point, other factors to consider include, among other things, the risk of buyer default on the payout and whether the earn-out is more or less risky than typical industry cash flows. Another alternative is to use the WACC that was used to calculate the enterprise value of the business in the acquisition, adjusted for any risks arising after the agreement was signed.
Milestone-based earn-outs are not exposed to market risk and are valued using a risk-free rate to discount probability-weighted payouts.
A standard discounted cash flow analysis (a DCF) is a form of SBM with only a single scenario representing an expected case. When valuing an earn-out using a DCF, the performance metric for the business is forecasted over the earn-out period and is compared to the relevant target to determine any payouts, which are then discounted to present value as of the acquisition date.
Generally, a DCF analysis is appropriate only when valuing an earn-out with a linear percentage payout formula. For example, an earn-out with a payout equal to 30 percent of the next fiscal year’s EBITDA is linear because it has a constant relationship to the underlying performance metric (i.e., a payout is due whether EBITDA is $1 million or $100 million).
Option Pricing Method (OPM)
The SBM approach is not well suited to capture the economics of more complex nonlinear structures, which feature, e.g., thresholds or caps, or where there are multiple performance metrics at play. The valuation of such complex payout formulas requires more sophisticated probabilistic methodologies, such as OPM, which incorporate assumptions about the full range of future outcomes rather than just a sampling of possible scenarios. Payout formulas that have a nonlinear structure are similar to options in that they are triggered when certain thresholds are reached.
The OPM treats earn-outs like call options on the future payouts and uses option models such as Black-Scholes. Option models work for simpler payout formulas, under which a payout is earned only if the business hits a target, or for linear graduated payout formulas with caps or floors.
For complex payout formulas that are path-dependent (e.g., where there are catch-ups, claw-backs, or multi-year features), a Monte Carlo simulation may be required.
Tax Issues
The parties may have adverse tax interests in the characterization of payouts, so the treatment should be addressed as early as possible. If treated as compensation for services, the payout will be treated as ordinary income to the seller (i.e., a negative implication) but will provide a compensation deduction to the buyer (i.e., a positive implication).
Alternatively, if the payout is treated as purchase price, the seller will be taxed at the lower capital gain rate (i.e., a positive implication), but the buyer will have to capitalize the cost (i.e., a negative implication).
The Internal Revenue Service will consider the facts and circumstances surrounding the payouts and has historically focused on the following factors:
whether the seller is required to provide services in order to be eligible for the payout;
whether the seller is otherwise adequately compensated for the performance of any required services;
whether the Payouts are proportionate to the seller’s equity in the business;
whether the total payouts made to the seller when viewed together with any upfront cash payments represent a reasonable price to be paid for the business;
the manner in which non-selling carryover employees are compensated for post-closing service; and
how the parties report the payouts for both tax and financial reporting purposes.
When a payout is properly considered compensation for services, it will be treated as taxable income when received by the service provider. The timing of the related deduction will depend upon the accounting method of the buyer. If the payout is treated as purchase price, special rules related to installment sales may apply. Additionally, an imputed interest component may apply to the deemed installment sale.
Other considerations with respect to earn-out payments:
The size of any cash payouts should not be of a magnitude to threaten a tax-free reorganization.
The size of any payout can also impact whether a Section 338(h)(10) election can be made.
If the business is to become part of a consolidated tax group, the seller should determine if any applicable tax sharing agreement will have an adverse effect on achieving any threshold.
Contingent Value Rights
Contingent value rights (CVRs) represent a version of an earn-out in transactions involving publicly traded companies. CVRs are particularly common in the pharmaceutical industry. As compared to traditional earn-outs, CVRs are usually of shorter duration and tied to the objectively verifiable outcome of a specific event, e.g., FDA approval of a drug.
A CVR can be deemed a security under applicable U.S. securities laws, subjecting the CVR to the registration requirements of the Securities Act at the time of closing. SEC no-action letters set out five essential factors that are needed for a CVR not to be considered a security:
the CVR is an integral part of the consideration to be received in a transaction,
the CVR is not represented by any form of certificate or instrument (usually not satisfied),
the holder has no rights common to stockholders (e.g., voting and dividend rights) and the earn-out does not bear a stated interest rate,
the CVR does not represent an equity or ownership interest in the buyer or the business, and
the CVR is not assignable or transferable, except by operation of law.
Conclusions
Earn-outs:
can be an effective negotiating tool when there are differing perspectives on value and/or outlook for the business;
have benefits and risks to both parties that should be considered prior to inclusion as an element of the purchase price;
are difficult because they can be manipulated by whoever is running the business;
must be carefully drafted to minimize the potential for litigation;
recognize and address potential conflicting incentives in the agreement;
require specificity regarding thresholds and milestones and measurement methods; use examples whenever possible; and
require definition of a clear set of responsibilities and contractual protections.
Post-closing adjustment arbitration provisions can be enforceable, but they may not preclude litigation of all causes of action arising from the acquisition.
Appendix: Representative Delaware Cases
Chambers v. Genesee & Wyoming Inc., 2005 WL 2000765 (Del. Ch. Aug. 11, 2005) (Chambers)
The earn-out in connection with the acquisition of the business by the Buyer (Genesee & Wyoming, Inc.) provided for a payout if the business achieved $9 million of EBITDA (as defined in the agreement) in any of the five years 1999–2003. Following the acquisition, the Buyer’s publicly reported EBITDA exceeded the threshold in four of the five years. The Buyer, however, claimed that EBITDA (as defined in the agreement) had not exceeded $9 million in any year and that the earn-out had not been earned.
The discrepancy arose because the Buyer adjusted its publicly reported EBITDA to reflect vested options, and those adjustments lowered the EBITDA of the business. Noting that “EBITDA…can be a slippery concept,” the Court focused on “the plain language of the contract itself” and noted that while the adjustments might have been appropriate under GAAP, the agreement specifically excluded them for the purposes of the earn-out. Moreover, the agreement did not permit the Buyer to expense certain labor costs (for purposes of the earn-out) that it had capitalized for its public financial statements. The Court therefore concluded that the Buyer’s calculation of EBITDA was flawed
William J. LaPoint v. AmerisourceBergen Corp., 2007 WL 2565709 (Del. Ch. Sept. 4, 2007), aff’d, 956 A.2d 642 (Del 2008) (LaPoint).
Under the agreement, up to $55 million was contingent upon the business meeting certain EBITA targets in 2003 and 2004. The agreement provided that the Buyer (AmerisourceBergen Corp.) would “exclusively and actively promote the [business],” would act “in good faith” during the earn-out period and would not do anything to impede the ability of the Seller (William J. LaPoint, as stockholder representative) to receive the payout. The Court called such terms “aspirational statements…and gossamer definitions…too fragile to prevent the parties from devolving into the present dispute.”
In his suit, the Seller alleged that the Buyer had not “exclusively and actively” promoted the business’s products and that the Buyer had turned down a proposal for a marketing relationship that would have been very favorable to the Seller under the earn-out.
Despite accepting the Seller’s allegation that the Buyer had failed to promote the business, the Court held that there was no evidence that the Buyer’s failure had made a difference insofar as the market was moving away from the type of product made by the Business. Thus, damages were awarded in the amount of six cents. The Court also held that the buyer was not obliged to enter into the marketing agreement.
The Seller fared better on the claim the earn-out calculation was in error. Among other things, the Court held that the Buyer could not adjust EBITA downward to account for incumbent management’s failure to invest in research and development as was required by the agreement. The Court noted the Buyer would have “done well to have included in the…agreement” an appropriate EBITA adjustment, but it declined to draft “any such clause into the agreement ex post.”
Under the agreement, sales to certain customers were to be discounted by an average discount (based on the last five contracts entered into before the execution of the agreement) in determining an adjustment to EBITA for earn-out purposes. The Buyer argued that the determination of average discount should be based on a weighted (by transaction size) average, which would have the effect of lowering EBITA. The Court rejected the argument because “the most straightforward usage of the term ‘average’ is an arithmetic mean.”
Overall, the Court characterized the Buyer’s arguments as “invok[ing] the agreement that it wishes it had signed, rather than the agreement that it drafted.” The cumulative changes resulted in an upward adjustment to the business’s EBITA of $6.2 million and a payout of $21 million, 44 percent of the total transaction price.
Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126 (Del. Ch. 2009) (Airborne Health)
Because the Buyer (Airborne Health, Inc.) and the seller (Squid Soap, LP) were unable to agree on the value of the business, the agreement provided for a cash payment of $1 million at closing, “plus the potential for…[payouts] of up to $26.5 million if certain targets were achieved.” Although the agreement provided that the Buyer would return the business to the Seller if the Buyer did not meet certain targets, such as advertising spend and sales volume, the agreement did not contain “any specific commitments by [the Buyer] regarding the level of efforts or resources that it would devote” to the marketing and sale of the business’s products.
Owing, in part, to significant litigation filed against the Buyer prior to the closing of the agreement that had not been disclosed to the Seller, the targets were not met and the Seller sued the Buyer for fraud and breach of the implied covenant. Owing to the specific wording of the Buyer’s representations in the agreement, the Court dismissed the claims for fraud.
The Court did agree with the Seller that “[w]hen a contract confers discretion on one party, the implied covenant requires that the discretion be used reasonably and in good faith” and that “[the Buyer] could not arbitrarily refuse to expend resources and thereby deprive [the Seller] of the prospects for the earn-out.” However, the Court recognized that the Buyer had suffered a “corporate crisis” and “was [u]ndoubtedly restrained by…legal and financial burdens” and that such a scenario did not support a claim that the buyer exercised its contractual discretion in bad faith.
Comet Systems, Inc. v. Miva, Inc., 980 A.2d 1024 (Del. Ch. 2008) (Comet Systems)
In calculating the earn-out, the Buyer (Miva, Inc.) treated bonus payments as an operating expense rather than a “one-time, non-recurring expense,” which was to be excluded from the calculation of “profit per user.” As a result, the profit per user target under the earn-out was not met and the payout was reduced significantly. The agreement did not specifically define the intended meaning of “one-time, non-recurring expense.” The Court concluded that the bonus payments qualified as a “one-time, non-recurring expense” pursuant to the “plain, unambiguous meaning of the agreement.” The Court observed that “charges and costs which occur as a result of the [acquisition] and are not expected to be representative of future costs in the business are reasonably excluded. The natural reading of ‘one-time, non-recurring expenses’ is to exclude exactly such charges.”
Winshall v. Viacom International Inc., 55 A.3D (del. Ch. Nov. 10, 2011), aff’d 72 A.3d 78 (Del. 2013) (Winshall I)
In 2006, the Buyer (Viacom International, Inc.) acquired the business (Harmonix Music Systems, Inc.) for $175 million in cash and contingent uncapped earn-out payments based on the financial performance of the business in 2007 and 2008.
Winshall (as Seller’s representative) challenged the Buyer’s earn-out calculation, and the dispute was put to a designated neutral accountant. Although it was not identified in its original calculation, the Buyer argued to the neutral accountant it should be allowed to deduct, or, in the alternative, take a write-down for, the cost of the business’s unsold inventory (the “inventory issue”). In its decision, the neutral accountant rejected the inventory issue because the Buyer had not identified it, as required by the agreement, in its initial calculation and the Seller did not agree to have it resolved by the neutral accountant.
The Buyer filed a complaint with the Court, seeking a declaration vacating the neutral accountant’s determination on the grounds that it constituted “manifest error.” The Court disagreed and granted Winshall’s motion for summary judgment.
On appeal, the Buyer argued, among other things, that (i) the neutral accountant’s refusal to consider evidence of the inventory issue amounted to misconduct and (ii) the inventory issue was one of substantive arbitrability, which should have been decided by a court. The DSC disagreed and concluded that (a) the neutral accountant’s refusal to consider the inventory issue without the consent of the Seller was appropriate and (b) the Inventory Issue was one of procedural arbitrability, properly decided by the neutral accountant.
Winshall v. Viacom International Inc., 2012 WL 3249620 (Del. Ch. Aug. 9, 2012), aff’d 76 A.3d 808 (Del. 2013) (Winshall II)
The representative of the Sellers (Winshall) claimed that the Buyer deliberately failed to renegotiate certain distribution fees in order to reduce the Seller’s payout. Given that the agreement did not obligate the Buyer to renegotiate the fees, the Court rejected the Seller’s argument that the implied covenant implicitly obligated the Buyer to avoid manipulating the cost structure of the business to lower the payout.
The DSC upheld, among other things, the Court’s rejection of the Seller’s claim, noting that “the implied covenant is not a license to rewrite contractual language just because the plaintiff failed to negotiate for protections that, in hindsight, would have made the contract a better deal.”
American Capital Acquisition Partners v. LPL Holdings, 2014 WL 354496 (Del. Ch. Feb. 3, 2014) (LPL Holdings)
The agreement provided for a payout based on the achievement of certain “gross margin” thresholds. The agreement, however, did not include any provision requiring the Buyer (LPL Holdings) to make, or to use any efforts to make, certain technical adaptations to its computer systems necessary to allow the business to expand and eventually meet those thresholds.
The Seller (American Capital Acquisition Partners) argued that the existence of contingent price provisions obligated the Buyer to make those adaptations under the implied covenant. The Court pointed out in its opinion that although the parties anticipated that the Buyer’s systems would require some changes, they did not include any provision in the agreement obligating the Buyer to make any technical adaptations necessary to allow the further development of the Business. The Court reiterated that the implied covenant serves only a gap-filling function that is only relevant when an issue arises ex post that was not anticipated when the contract was negotiated. Here, the Seller “anticipated, but failed to bargain for, a requirement that [the Buyer] adapt [its] software and data-handling capabilities.”
At the same time, the Court did find that the Buyer breached the implied covenant by allegedly diverting the Seller’s clients and employees to another subsidiary of the Buyer and discouraging clients and prospective clients from using the Seller’s resources.
Lazard Technology Partners, LLC v. Qinetiq North America Operations LLC, 114 A.3d 193 (Del. 2015) (Lazard Technology)
The Buyer (Qinetiq North America Operations LLC) paid the Seller (Lazard Technology Partners, LLC, as stockholder representative) $40 million for the business, plus a potential earn-out of $40 million if the business reached certain revenue levels. The agreement prohibited the Buyer from taking “any action to divert or defer [revenue] with the intent of reducing or limiting the…[Payout].” When the business did not reach the requisite target, the Seller sued the Buyer for violating the contractual prohibition and the implied covenant.
After trial, the Court held that the Seller failed to prove that the Buyer acted with the requisite intent to violate the agreement. Owing to the existence of the express covenant not to take action “with the intent of reducing or limiting the…[payout],” there was not an implied covenant inconsistent with that express covenant.
The DSC upheld the lower court’s bench ruling. According to the DSC, the plaintiff had the burden to establish that the Buyer’s action was “specifically motivated by a desire to avoid the earn-out.” In that regard, the plain language of the agreement limited the Buyer’s actions only if they were done with the motivation to avoid the earn-out. Furthermore, because the agreement specifically set forth the standard for the Buyer’s behavior, the Seller’s argument was without merit.
The Buyer (Dialog Semiconductor PLC) was required to “use commercially reasonable best efforts” in managing the business to achieve the earn-out. The agreement also included specific obligations and prohibitions on the Buyer’s operation of the business.
When the business failed to achieve the earn-out threshold, the Seller (through Fortis Advisors) brought suit alleging, among other things, breach of contract and, in the alternative, breach of the implied covenant.
As the agreement expressly obligated the Buyer to use commercially reasonable best efforts and explicitly restricted the Buyer from taking certain actions, the Court rejected the assertion that the implied covenant could be used as an alternative theory to contractual breach with respect to the earn-out provision in dispute.
The Seller (Haney) sued for, among other things, breach of the implied covenant when the business failed to reach an earn-out target. The Seller alleged that the Buyer (Blackhawk Network Holdings Inc.) deliberately prevented the business from achieving the Target by failing to devote required resources to the business.
The Seller argued that the agreement’s requirement that the Buyer’s “key personnel…dedicate a commercially reasonable” amount of time and resources to the generation of revenue did not specifically provide a standard for evaluating the conduct of the Buyer’s personnel. (The argument was intended to distinguish from Dialog Semiconductor where the Court held that an agreement’s “best efforts” standard and specified Buyer obligations barred applying the implied covenant.)
The Court disagreed, finding that the express terms of the agreement controlled, and dismissed the Seller’s claim. The Court, however, did find that the Seller’s allegation that the Buyer failed to disclose an exclusivity provision in a key contract (which precluded the achievement of the relevant target) stated a claim for unjust enrichment based on fraud.
Zhu v. Boston Scientific Corp., 2016 WL 1039487 (D. Del. Mar. 15, 2016) (Boston Scientific)
A federal court applying Delaware law concluded that the failure to develop a medical technology in a manner that would have allowed the Seller (Zhu) to receive a payout did not constitute a breach of the implied covenant. The Court concluded that the Sellers “simply disagree with how [the Buyer (Boston Scientific Corp.)] chose to develop the [t]echnology” and that commercially reasonable conduct does not rise to the level of a breach of good faith.
Sharma v. TriZetto Corp., 2016 WL 1238709 (D. Del. March 29, 2016) (TriZetto)
The Seller (Sharma) sold the business to the Buyer (TriZetto Corp.) for $13.5 million in cash plus additional consideration in an earn-out if the Business achieved gross revenues of $47.2 million in the 2013 calendar year.
The parties anticipated that the Buyer would engage in subsequent acquisitions, and the agreement provided that the parties would negotiate in good faith to determine whether revenue from such acquisitions would apply toward the earn-out revenue goal. As a default, until the parties agreed otherwise, the revenue from those acquisitions would not be applied against the goal.
After objecting to the payout calculation, the Seller sued claiming that the Buyer breached the agreement by operating the business to avoid owing the payout, by failing to include post-closing acquisitions in the payout calculation, by failing to engage in good-faith negotiations or provide reasonable details concerning the earn-out calculations, by failing to appoint a neutral accountant to resolve the dispute between the parties, and by failing to maintain and promote the business.
The District Court (applying Delaware law) dismissed the claim for breach of contract, holding that the Seller had failed to allege facts that suggested that the Buyer made its decisions to avoid the earn-out payment. Because the agreement did not require the Buyer to make any specific disclosures in connection with the earn-out calculation statement, and because the parties had over ten months of discussions concerning the earn-out calculation, the Court held the plaintiffs had not alleged sufficient facts to support a claim that they failed to engage in good faith negotiations or to supply reasonable detail regarding its calculation. Because the dispute concerned which of the acquired businesses were part of the business, the issue was deemed outside the purview of the neutral accountant. Lastly, the Court held that the alleged facts did not fall into a “gap” in the agreement that would require the operation of the implied covenant.
Shareholder Representative Services LLC v. Gilead Sciences Inc. et al., 2017 WL 101561 (Del. Ch. Mar. 15, 2017), aff’d 177 A.3d 610 (Del. 2017) (Gilead Sciences)
The Buyer (Gilead Sciences Inc.) purchased the business for $375 million plus a series of three milestone payments if the business’s principal cancer drug obtained certain regulatory approvals, two of which were obtained.
The third $50 million payout was due upon regulatory approval of the drug in the United States or European Union as a “first-line drug treatment…for a Hematologic Cancer Indication.” When the drug was approved by the European Union as a first-line treatment for patients with chronic lymphocytic leukemia, but only those with a specified genetic mutation, the parties disputed whether the final milestone had been met.
Finding that the use of the word “indication” to describe the milestone was ambiguous, the Court reviewed the extrinsic evidence to determine that when the parties entered into the agreement, they mutually understood that the term “indication” meant “a disease.” Because the drug had been approved only for a specific subset of patients having leukemia, rather than having been approved as a first-line treatment of the disease called leukemia, the Court determined that the requisite milestone had not been achieved.
The Seller (Sprout Pharmaceuticals), which had developed a “female Viagra” drug (Addyi), entered into an agreement that required the Buyer (Valeant Pharmaceuticals) to use “diligent efforts” to pursue the development and “commercialization” of Addyi.
The agreement had explicit definitions of the required post-closing “diligent efforts” required of the Buyer, specifying both general standards plus four specific requirements on matters like minimum spending and staffing.
The Seller’s representative alleged that the Buyer’s high pricing of Addyi, while not contrary to any of the requirements of the agreement, violated the implied covenant by being unreasonable and therefore causing sales to be lower than anticipated.
Notwithstanding that the agreement covered “commercialization” of Addyi, the Court held that it could not dismiss an argument that “pricing” was separate from “commercialization,” and, therefore, there was a gap that could be filled by the implied covenant. The Court made a similar finding about the Buyer’s decision to sell Addyi through a pharmacy channel that was under criminal investigation.
Fortis Advisors LLC v. Shire US Holdings, Inc., 2017 WL 3420751 (Del. Ch. Aug. 9, 2017) (Shire)
The Seller’s representative (Fortis Advisors LLC) sought the payment of two milestone payouts totaling $425 million. The first milestone required the occurrence of an “achievement date,” which was defined in the agreement as satisfaction of certain efficacy endpoints in a study of a drug for dry eye disease (the “Study”). The second milestone was payable upon receipt of regulatory approval for the drug, contingent on the prior occurrence of the achievement date milestone.
The drug did not meet the required Study endpoints by the achievement date. However, the Buyer (Shire US Holdings, Inc.) continued development of the drug, which ultimately gained regulatory approval using the results of the Study as well as clinical data from other studies conducted prior to the Study (the “Prior Studies”).
The Sellers argued that the agreement should be interpreted as allowing consideration of the Prior Studies, not just the Study, in determining whether the endpoints had been achieved for purposes of determining whether the achievement date had occurred.
The Court held that since the “achievement date” was defined by reference to the outcome of a specific Study, the first milestone was not met because the endpoints of that Study were not met.
The Court rejected the Sellers’ argument that the first milestone did not expressly exclude consideration of other studies, and, therefore, the results of the Prior Studies could be included, noting that the agreement specifically referenced the Study and did not reference the results of other clinical studies.
The Court also found that since the second regulatory approval milestone was contingent on the occurrence of the achievement date, which was not met, the regulatory approval milestone was also not met.
GreenStar IH Rep., LLC v. Tutor Perini Corp., 2017 WL 5035567 (Del. Ch. Oct. 31, 2017) (Tutor Perini)
The agreement pursuant to which the Buyer (Tutor Perini Corp.) bought the business provided for the Seller (GreenStar Services Corp.) to receive payouts over five one-year terms. For each term, the Seller was entitled to a payout equal to 25 percent of the business’s pre-tax profit in excess of $17.5 million, up to a cap of $8 million. Any excess amounts (a surplus) that would have been paid but for the cap were to be applied to any ensuing payouts falling short of the cap.
The agreement required the Buyer to calculate pre-tax profit and provide the calculation to the Seller’s shareholder representative. If the representative accepted the calculation or did not object to it within 30 days, the Buyer was obligated to pay the payout it had calculated. If there was an objection to the calculation, the parties were required to try to resolve the dispute and, failing a resolution, to submit the matter to arbitration by a neutral accountant.
After making the first two annual payouts (capped in each case at $8 million, with $9.2 million surplus available to use in future years), the Buyer claimed that it had come to suspect that incumbent management had supplied false information to raise the reported profits of the business. Although the Buyer calculated pre-tax profits for the third and fourth years (which were materially lower than the first two years and were not objected to by the Seller’s representative), it did not make the required payout to the Seller (despite the $9.2 million Surplus from the first two years). In the fifth year, the Buyer neither calculated the pre-tax profit nor made a Payout.
As a counterclaim to the Seller’s suit for the unpaid payouts, the Buyer asked the Court to rule, among other things, that it was not obligated to make the payouts for the third, fourth, and fifth year due to the fraudulently inflated pre-tax profit numbers.
The Court rejected the counterclaim, holding that the agreement did not permit the Buyer to withhold payouts if it doubted the accuracy of the information that was used to calculate pre-tax profit. The agreement only provided a dispute resolution mechanism under which if the Seller objected to the Buyer’s earn-out calculation, there would be binding arbitration. As the Seller had not objected to the calculations, the Court ordered the Buyer to make $20 million in payouts for the third, fourth, and fifth years. The Court noted that the Buyer could have negotiated for the right to withhold a payout if it doubted the accuracy of the information on which it was calculating the pre-tax profit of the Business.
In a subsequent proceeding (GreenStar IH rep, LLC, et al. v. Tutor Perini Corp., C.A. No. 12885-VCS, memo op. (Del. Ch. Dec. 4, 2019), or Tutor Perini II), the Court addressed an escrow release agreement that the parties had entered into that provided for payouts to the Seller only if certain accounts receivable were collected. In adjudicating whether the condition had been satisfied, the Court found that the agreement, though not a model of clarity, was unambiguous when read together with an incorporated exhibit illustrating its operation and when “read in full and situated in the commercial context between the parties.”
The Buyer (Exelon Generation) agreed to make payouts to the Seller (Deere & Co.) if certain milestones were reached in the development of three wind farm projects that were underway at the time of sale. One of the projects became impossible to develop due to local ordinances that were passed. An issue arose as to whether the development by the Buyer of another wind farm 100 miles away, that was not referenced in the agreement, could satisfy one of the milestones that would trigger the payout.
The DSC reversed the Delaware Superior Court and rejected the earn-out claim based on the application of contract interpretation principles. Specifically, the DSC noted that if a contract is unambiguous, extrinsic evidence may not be used to interpret the intent of the parties, to vary the terms of the contract, or to create an ambiguity. In addition, in interpreting an earn-out provision, the parties’ post-closing conduct may be used to determine whether there is a breach, but post-closing evidence cannot be used as an aid to interpreting the meaning of the contract when the contract is unambiguous.
Edinburgh Holdings, Inc. v. Education Affiliates, Inc., 2018 WL 2727542 (Del. Ch. June 6, 2018) (Edinburgh Holdings)
The agreement pursuant to which the business was sold provided for four annual contingent payouts based upon the revenue of the business, which was to be managed by the incumbent management “in a reasonable manner and consistent with the past practices of the Seller (Edinburgh Holdings, Inc.).”
After making three payouts, the Buyer refused to make the fourth and the Seller sued to obtain the payout. The Buyer sought dismissal on the basis that the business had not been operated by the incumbent management “consistent with past practices.”
The Court refused to grant the Buyer’s motion to dismiss because the issue of whether the business was operated consistent with past practices was fact-intensive and therefore could not be decided at the pleading stage.
The Court also ruled that the Seller’s implied covenant claim was inapplicable because the agreement expressly set forth a standard for operation of the business during the earn-out period. The Court further noted that a claim for breach of the implied covenant can be maintained only if the factual allegations underlying the claim differ from those underlying an accompanying breach of contract claim.
Fortis Advisors LLC v. Stora Enso AB, 2018 WL 3814929 (Del. Ch. Aug. 10, 2018) (Stora Enso)
The Seller’s representative (Fortis Advisors LLC) alleged that two payouts were owed to it based on the achievement of two milestones, the first of which required the construction of a plant and the completion of the production of certain other products, and the second of which required the construction of a separate plant and the production of certain products at a specific price by a specific deadline. The claim for breach of contract alleged that the Buyer (Stora Enso AB) did not comply with the business plan that was part of the agreement and failed to take the actions required to be taken for the payouts to be due.
The Court observed that in a motion to dismiss, the movant can only prevail if its proffered interpretation of the agreement is the only reasonable interpretation. Here, the interpretations of the agreement by each of the parties were both reasonable, and, therefore, as a procedural matter, the Court found that granting the Buyer’s motion to dismiss was inappropriate.
Four hundred million dollars in payouts were contingent on the continued development and commercialization by the Buyer (Cephalon, Inc.) of a particular antibody, with $200 million being payable upon regulatory approval of the antibody for each of two medical conditions.
The agreement required the Buyer to use “commercially reasonable efforts” to develop the antibody and achieve the milestones, with “commercially reasonable efforts” defined as “the exercise of such efforts and commitment of such resources by a company with substantially the same resources and expertise as [the Buyer], with due regard to the nature of efforts and cost required for the undertaking at stake.”
The Buyer received relevant regulatory approval for one of the identified conditions and paid the Seller $200 million. The Buyer, however, abandoned development and commercialization of the antibody for the second identified condition, foreclosing the possibility of the second $200 million payout and prompting a lawsuit by the Seller (Himawan) for breach of contract.
In denying a motion to dismiss, the Court focused on the requirement that the Buyer expend efforts that companies with substantially the same resources and expertise would expend in the circumstances at hand and noted that it was unclear what additional obligations, if any, were imposed upon the Buyer by such language. Because the Sellers alleged that the Buyer abandoned efforts toward the second milestone while companies with similar resources and expertise continued to pursue them, the Court found dismissal inappropriate.
The Buyer (Beumer Corp.) acquired 60 percent of Seller (Glidepath Ltd.) upfront, with the remaining 40 percent to be acquired three years later at a price dependent upon the future performance of the business.
The agreement stated that the earn-out period covered “fiscal years 2014, 2015 and 2016.” Although the parties expected to sign the agreement shortly before the commencement of the Seller’s fiscal 2014 year, the signing and closing did not take place until several months later. Notwithstanding the change in signing date, the specified earn-out period remained unchanged.
During the period of the Seller’s minority ownership, the Buyer (which had primary control over the venture) reoriented the business towards longer-term projects and invested in training personnel, which depressed the short-term profits of the business.
When it became apparent that the Seller would not be entitled to much, if any, of the earn-out, the Seller sued for, among other things, breach of fiduciary duty, contending that the Buyer “disloyally engag[ed] in a scheme to depress revenues, increase expenses and divert business opportunities for their own benefit.”
Though finding that the Buyer owed fiduciary duties as a manager and controlling shareholder, the Court held that, because Delaware LLCs exist perpetually, the default duty must be to “maximize the value of the LLC over a long-term horizon,” rather than maximizing the value of a beneficiary’s contractual claim against the Buyer.
Although there was no breach of fiduciary duty, the deal structure did create a conflict of interest that was subject to entire fairness review. However, the Court found that focusing on large-scale projects was a valid business strategy and promoted the value of the LLC. According, the Buyer’s conduct was found to be entirely fair even though it did not maximize the Seller’s contingent consideration.
Western Standard, LLC v. SourceHOV Holdings, Inc., 2019 WL 3322406 (Del. Ch. July 24, 2019) (Western Standard)
Pursuant to the agreement by which the Buyer (SourceHOV Holdings, Inc.) acquired the business, the Sellers (represented by Western Standard LLC) were entitled to a payout if a “realization event” occurred within seven years of closing. During the earn-out period, the Buyer undertook several merger transactions, which resulted in a demand from the Sellers to receive the payout, as they interpreted the transactions to all be within the scope of the definition of a realization event. The Buyer moved to dismiss, arguing that the agreement stated that mergers of the type undertaken by the Buyer would not be considered a realization event.
The Court confessed that it was “unable to divine any meaning from the contract” and found that neither party provided an interpretation of realization event that made sense; therefore, the Court denied the motion to dismiss to allow the parties to present extrinsic evidence that would allow the Court to discern the meaning of the relevant provisions of the agreement.
Windy City Investments Holdings, LLC v. Teachers’ Insurance and Annuity Assoc. of America, C.A. No. 2018-0419-MTZ (Del. Ch. July 26, 2019) (WindyCity)
The Buyer (Teachers’ Insurance) acquired the business (Nuveen, Inc.) from the Seller (Windy City Investments) for $6.25 billion, plus an earn-out based on the profitability of the business of between $45 million (if the specified floor targets were met) and $278 million (if the specified target caps were met). The earn-out was based on the “cumulative advisory revenues” and net flows of the business during the four-year earn-out period. The floor and cap targets were to be adjusted (upward or downward, respectively) “in the event of acquisitions or dispositions” of investment accounts from non-[Buyer] affiliated parties. The agreement also provided that the Seller would receive the maximum payout if the business was sold.
Cumulative advisory revenues included 50 percent of revenues derived from investment accounts advised by the Buyer and excluded advisory revenues derived from the Buyer’s general investment accounts. Net flows were to be based on increases in assets under management by the business less withdrawals, and they included 50 percent of third-party accounts advised by the Buyer and excluded general assets of the Buyer.
Among other things, the agreement provided that the Buyer would not take “any action the intent of which is to reduce the [payout]” and that the Seller would have “reasonable access to relevant personnel (including accountants), work papers, and books and records related to the [Business]”. Disputes with respect to the earn-out were to be submitted to a neutral accountant for resolution; however, the parties were obligated to seek judicial interpretation of any disputed contract terms, with the neutral accountant being bound by such interpretation in making its calculations.
A dispute arose as to how revenues and flows from investment products advised or managed solely by the Buyer, but distributed through the business, were to be treated. The Seller believed it was entitled to 50 percent credit for any gains from such products, whereas the Buyer believed the Seller was only entitled to credit for gains from investment products with respect to which the business was the advisor.
In a subsequent suit, the Court rejected the Buyer’s motion to dismiss, finding that “[n]either party provide[d] the only reasonable interpretation” of the disputed language and that the parties’ respective interpretations “require[d] the Court to minimize deliberately placed language or, in some cases, import extra-contractual concepts to reconcile that language.”
The Court also refused to dismiss the Seller’s claims (i) that the Buyer breached the agreement in connection with the sale of certain businesses in a manner intended to depress the Seller’s payout and (ii) for access to the books and records of the business.
Collab9, LLC v. En Pointe Technologies Sales, LLC, C.A. No. N16C-12-032 MMJ CCLD (Del. Super. Sept. 17, 2019) (En Pointe)
The Buyer (En Pointe Technologies) acquired substantially all of the assets of the business from the Seller (Collab9 LLC) pursuant to an agreement which provided for payout calculated as a percentage of the business’s adjusted gross profit over several years.
The agreement provided that the Buyer would have “sole discretion with regard to all matters relating to the operation of the business” and would have no obligation, express or implied, to take any action, or omit to take any action, to maximize the payout.
The Seller brought suit for breach of contract, for breach of the implied covenant, and for fraud based upon alleged inaccuracies in the Buyer’s quarterly earn-out certifications.
The Court dismissed the claims for breach of the implied covenant and for fraud. Given the agreement’s “comprehensive and explicit” language controlling the obligations of the parties with respect to operating the business post closing, there was no place for the gap-filling role of the implied covenant under the circumstances. The Court found that the Seller’s fraud claim, based upon the Buyer’s alleged failure to respect duties under the agreement, amounted to a deficient “repackaging” or “bootstrapping” to its breach of contract claim.
The Buyer (Allergan) paid $125 million at closing and contracted for payments of up to $300 million upon certain milestones for a device for the treatment of dry-eye disease (the Device). The first milestone was achieved, and the Buyer paid $100 million to the Seller.
The second $100 milestone required FDA authorization of the Device’s use for “the treatment of at least one Dry Eye Disease Symptom (the “Labeling Milestone”).” The agreement required the Buyer to use “commercially reasonable efforts” to achieve the Labeling Milestone. “Commercially reasonable” was further defined to include “expending resources that [the] Buyer would typically devote to…products of similar market potential at a similar stage of development.”
The FDA approved a label for the Device that indicated that the product “provides a temporary increase in tear production…to improve dry eye symptoms in adult patients with severe dry eye symptoms.” In turn, the Buyer claimed the Labeling Milestone was not achieved because the FDA approval did not include “treatment” or “disease” and because the increase in tear production was “temporary.”
The Seller (Fortis Advisors, as representative) brought suit alleging breach of the agreement due to the Buyer’s refusal to make the second milestone payment and for its failure to use “commercially reasonable efforts” to achieve the Labeling Milestone.
The Court rejected the Buyer’s motion to dismiss, concluding that the FDA approval of an indication for use of the product “to improve dry eye symptoms” satisfied the Labeling Milestone requirement of “treatment of dry eye symptoms.” The Court also concluded that the indication of “temporary” did not preclude satisfaction of the Labeling Milestone. Moreover, the indication for “severe” dry eye symptoms did not matter because the Labeling Milestone did not specify a specific patient population to be addressed by the device.
The Court also credited the Seller’s allegation that the Buyer waited two years before applying to the FDA for a label for the Device and then waited four months to reapply when the FDA rejected the Buyer’s first labeling application. The Court determined that the allegations supported a reasonable inference that the Buyer’s efforts “fell short of its comparable efforts for other similar products,” as required by the agreement.
MarkDutchCo 1 B.V. v. Zeta Interactive Corp., C.A. No. 17-1420-CFC (D. Del. Nov. 12, 2019) (MarkDutchCo)
The Seller (MarkDutchCo) sold its interest in the business (customer relation management) to the Buyer (Zeta Interactive Corp.) for $23 million in cash, shares of Zeta common stock, and several earn-out payments, the first of which required a payout of $4 million if the business’s EBITDA was at least $10 million during the 12-month earn-out period following closing. The agreement required the Buyer to deliver to the Seller a statement detailing the Buyer’s determination of EBITDA for the relevant period and its calculation of the associated payout. The agreement gave the Seller the right to “review all [the] materials and information” the Buyer used to prepare the calculation. The Seller could dispute the Buyer’s calculation by providing a written objection notice within ten business days, setting forth “in reasonable detail [its] alternative calculations (if any), together with reasonable supporting details.”
The Seller sent an objection notice disputing the entirety of the Buyer’s calculation but did not include an alternative EBITDA calculation because it lacked sufficient information. The Buyer claimed the notice was therefore invalid and its calculation was final and binding. After receiving more information, the Seller sent a supplement to its objection and calculated an EBITDA for the business that was significantly higher than the $10 million target. The Seller also submitted the dispute to a neutral accountant, who was to be “the sole arbiter of all matters, procedural and/or substantive, as to such Disputed Payment Amount.” The neutral accountant’s determination was to be final and binding absent “fraud, bad faith or manifest error.” Ultimately, the neutral accountant found the EBITDA to be in excess of the target, and the Seller sued for confirmation of the $4 million payout under the FAA.
In its counterclaim, the Buyer alleged that the Seller misrepresented the validity of certain patents and that such misrepresentations were fraudulent and constituted a breach of the representations in the agreement, entitling the Buyer to without the payout. The Buyer also alleged, among other things, that the neutral accountant exceeded his scope of powers by considering the Seller’s supplement. The District Court (applying Delaware law) disagreed, finding that because the Seller was only required to provide an alternative calculation “to the extent possible based on the information available to [it],” the neutral accountant was within the scope of his powers in accepting the supplement following receipt of the required information from the Buyer.
In affirming the neutral accountant’s award, the Court also rejected the Buyer’s counterclaims and indemnity offsets as being outside the ambit of the arbitration confirmation proceeding or as being time barred.
The Buyer (Mitchell International, Inc.) bought a business from the Seller (Quaram) that developed review and approval processes from reimbursement and insurance claims. The Buyer and the Seller entered into an earn-out agreement that allowed the Seller to earn additional compensation for two years after the sale. Pursuant to the agreement, the Buyer had “the power to direct the management, strategy and decisions” of the business post closing. However, the Buyer also agreed that it would “act in good faith and in a commercially reasonable manner to avoid taking actions that would reasonably be expected to materially reduce the earnout.” The Buyer also agreed to “act in good faith and use commercially reasonable efforts to present and promote” the acquired company’s products “to customers that could reasonably be expected to utilize them.” Lastly, the Buyer agreed to upgrade or build a bridge between the Buyer’s existing systems and those of the acquired business within six months of closing so as to allow the Buyer to sell the acquired company’s products to its existing customers and to assist in calculating the earn-out.
The Seller entered into a two-year employment agreement with the Buyer to assist with the post-closing marketing and business. After the Seller was terminated by the Buyer, the Seller brought suit alleging breach of the earn-out covenants. The Superior Court denied the Buyer’s motion to dismiss certain of the Seller’s allegations.
The Court viewed the first earn-out covenant as one requiring the Buyer to refrain from positive actions that reasonably could be expected to reduce the earnout or impede calculating the earnout. In that regard, the Court indicated that the covenant’s obligation did not extend to “avoiding inaction,” inasmuch as to do so would give the Seller the “power to manage the company.” Examples of such inaction related to “decisions and strategies [the Buyer] could have pursued but did not,” such as consulting with the Seller on marketing.
The claims that survived the motion to dismiss focused on positive actions, such as “routinely cancel[ing] regularly scheduled calls to prevent [the Seller] from promoting and selling” the products, making improper accounting decisions concerning minimum thresholds for bills, and diverting revenue to different products to avoid paying the earn-out.
With respect to the third provision of the earn-out agreement, the Buyer argued that the Seller could not plead damages resulting from the Buyer’s decision to build an alternative bridge between the parties’ systems. The Court, however, found that it was reasonable to infer from the agreement that a specific solution was necessary to provide services to customers and calculate the earn-out amount and that failing to build that solution could constitute damages.
Shareholder Representative Services LLC v. Albertsons Companies, Inc., 2021 WL 2311455 (Del. Ch. June 7, 2021)
The Sellers were the former stockholders in DineInFresh, Inc. (d/b/a Plated), an e-commerce subscription meal-kit delivery company (Plated) whose business model involved consumers subscribing to its services in exchange for ingredients and recipes for home-cooked meals being delivered to their homes. In September 2017, the Sellers and the Buyer entered into a merger agreement pursuant to which the Buyer acquired the Sellers for $175 million in cash and an earn-out of $125 million, payable over three years.
The merger agreement gave the Buyer the right to make all post-closing business and operational decisions “in its sole and absolute discretion” and expressly stated that it would have “no obligation to operate [Plated] in a manner to maximize achievement of the [earn-out].” However, that right was subject to a provision obligating the Buyer not to “take any action (or omit to take any actions) with the intent of decreasing or avoiding” payment of the earn-out.
In the litigation, the plaintiff, on behalf of the Sellers, contended that the earn-out was premised on Plated’s historical and projected performance and that the Buyer had repeatedly provided assurances throughout the merger negotiation 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. Instead, immediately upon closing of the merger, the Buyer directed Plated to reallocate its resources to get a retail version of its product into 1,000 of the Buyer’s stores in the space of one week. In addition, the plaintiff alleged that the Buyer interfered with employment decisions and generally mismanaged the business, including by failing to take advantage of preferred pricing and financing opportunities. Thereafter, Plated missed its earn-out milestones and the Buyer did not make the earn-out payment to the Sellers.
The plaintiff alleged that Plated would have succeeded and at least a portion of the earn-out would have been paid but for Albertsons’s active interference with Plated’s business. The plaintiff asserted three causes of action: (i) breach of contract by acting with the intent of avoiding the earn-out, (ii) breach of the implied covenant, and (iii) fraudulent inducement.
The Court held that the plaintiff’s allegations were sufficient to support a reasonable inference that the Buyer breached the earn-out agreement inasmuch as those well-pleaded allegations suggested that the Buyer knew that changing Plated’s business model would cause the company to miss the earn-out milestones and that the Buyer’s actions were motivated at least in part by a desire to avoid the earn-out. The Court reasoned that even if the Buyer took its actions only in part with the purpose of causing Plated to miss the earn-out milestones, this was enough at the pleading stage to support the plaintiff’s breach of contract claim.
The Court dismissed the plaintiff’s implied covenant claim, finding that the merger agreement gave the Buyer the absolute discretion to run the business in good faith. Accordingly, there was no contractual gap to fill. The Court also rejected the plaintiff’s fraudulent inducement claim based on the Buyer’s alleged misrepresentations during the merger agreement negotiation. The Court found that such misrepresentations were future promises and statements of intent with respect to post closing operations and that the Sellers were not justified in relying on such misrepresentations.
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Airborne Health, Inc. vs. Squid Soap LP, 984 A.2d 126 (Del. Ch. 2009). ↑
The average transaction value of the 151 target companies in the ABA Study was $207.8 million. ↑
Earn-outs made up 27 percent of the consideration in the (non-life sciences) transactions between the 2014–2018 review in SRS Acquiom’s 2019 M&A Deal Terms Study (the SRS Study). ↑
Unless otherwise specified, case citations and summaries are found in the appendix. ↑
Approximately 31 percent of the earn-out provisions in the ABA Study used EBITDA as the principal performance metric; 29 percent used revenue. ↑
In the ABA Study, 66 percent of the agreements contained such a provision, whereas 76 percent of the agreements in the SRS Study contained such a provision. ↑
Eighty percent of the agreements in the SRS Study had earn-out periods of 1–3 years. However, longer earn-out periods were present in Chambers (five years), Tutor Perini (five years), Edinburgh (four years), Western Standard (seven years), and Windy City (four years). ↑
Twenty-two percent of the agreements in the ABA Study and 21 percent of the agreements in the SRS Study contained such a provision. ↑
Found in 33 percent of the agreements in the ABA Study. ↑
Found in 15 percent of the agreements in the ABA Study. ↑
Found in 17 percent of agreements in the ABA Study and 14 percent of the agreements in the SRS Study. ↑
Found in ten percent of the agreements in the ABA Study and three percent of the agreements in the SRS Study. ↑
The Seventh Circuit issued a resounding message: Delaware forum selection clauses in corporate bylaws cannot lawfully prevent a plaintiff from bringing claims under the Securities Exchange Act of 1934 (the Exchange Act or the Act) in federal court. The Court, in its decision in Seafarers Pension Plan v. Bradway,[1] chose not to follow other federal courts that have enforced Delaware forum selection clauses in corporate bylaws to effectively bar shareholders from bringing Exchange Act claims.[2]
Although Section 115 of the General Corporation Law of the State of Delaware (Section 115) authorizes the adoption of forum selection bylaw (and charter) provisions that “require, consistent with applicable jurisdictional requirements, that any or all internal corporate claims shall be brought solely and exclusively in any or all courts in this State,” the Seventh Circuit’s decision is not inconsistent with the statute. Notably, while the Court did not look to the legislative history of Section 115, the synopsis for Senate Bill No. 75, the legislation that enacted the 2015 amendments to the General Corporation Law of the State of Delaware (the DGCL), including Section 115, states in pertinent part: “Section 115 also is not intended to authorize a provision that purports to foreclose suit in a federal court based on federal jurisdiction.”[3]
Overview of the Decision
The Seafarers dispute arose from the temporary grounding of all 737 MAX airliners following two airplane crashes in 2018 and 2019 that killed 346 people. Seafarers Pension Plan brought a derivative action in the Northern District of Illinois on behalf of Boeing under Section 14(a) of the Exchange Act of 1934,[4] alleging that officers and directors of Boeing made materially false and misleading public statements in proxy materials related to the development and operation of the 737 MAX airliner. The defendants moved to dismiss the action based on a forum selection clause in the Boeing bylaws, which provided that “the Court of Chancery of the State of Delaware shall be the sole and exclusive forum . . . for any derivative action . . . .” The district court agreed with the defendants and dismissed the case.
The Seventh Circuit reversed the district court in a 2–1 decision. The Court began by recognizing that the Exchange Act gives federal courts exclusive jurisdiction over claims brought under the Exchange Act.[5] Furthermore, the Exchange Act contains an anti-waiver provision that prohibits contractual waivers of compliance with the requirements of the Act.[6] Against this backdrop, the Court considered whether Boeing’s forum selection clause, as applied to the plaintiff’s §14(a) claim, complied with Delaware statutory law and concluded that it did not.
The Court first turned to Section 115, which provides that a corporation’s bylaws, “consistent with applicable jurisdictional requirements,” may require that internal corporate claims be brought “in any or all of the courts in this State.”[7] The Court focused on two aspects of Section 115: the requirement that a forum selection clause be “consistent with applicable jurisdictional requirements” and the reference to “the courts in this State” (emphasis supplied). The Court determined that Boeing’s forum selection clause was inconsistent with exclusive federal jurisdiction for claims brought under the Exchange Act. As the Court explained, by requiring that such actions must be brought in the Court of Chancery of the State of Delaware, the Boeing forum selection clause effectively barred plaintiffs from bringing a derivative claim under Section 14(a). Additionally, the Court emphasized that Section 115 refers to “the courts in this State,” rather than “the courts of this State,” which indicates that Section 115 contemplates forum selection clauses encompassing both federal and state courts located in Delaware.
While the Court did not look to the legislative history of Section 115, the synopsis for Senate Bill No. 75, the legislation which enacted the 2015 amendments to the DGCL, including Section 115, states in pertinent part: “Section 115 also is not intended to authorize a provision that purports to foreclose suit in a federal court based on federal jurisdiction.”[8]
In a dissenting opinion, Judge Easterbrook questioned whether a federal right to pursue a derivative claim under §14(a) exists, noting that the U.S. Supreme Court “has never held or even intimated” that there is such a right.[9] Judge Easterbrook also questioned the notion of exclusive federal jurisdiction in the context of a derivative action, since state law defines how and when such actions can be brought.
Impact of Decision
Given the Court’s reliance on Delaware law to provide a rationale for its holding, the most obvious question arising from this decision is whether Delaware courts will agree with the Seventh Circuit’s interpretation of Section 115. Considering the legislative history of Section 115, which neither the majority—nor Judge Easterbrook’s dissent—mentioned, it is likely that the Delaware courts will conclude that Section 115 cannot be used to deprive shareholders of the ability to bring claims arising under federal law in Delaware federal courts. The Delaware Chancery Court will have an opportunity to address this very question in a class action brought by Seafarers in Delaware under the same facts. In the Chancery Court action, stayed pending the outcome of the Seventh Circuit appeal, Seafarers challenges the legality of the forum-selection clause under Sections 115 and 109(b) of the Delaware General Corporation Law.
The Ninth Circuit also will have a chance to weigh in on this issue, where a decision of the district court for the Northern District of California in Lee v. Fisher is currently under appeal. The forum-selection clause in Fisher is identical to the one at issue in Seafarers: it requires that actions be brought in the Delaware Chancery Court. Similar to the district court in Seafarers, the Fisher Court enforced the forum-selection clause and dismissed the action. Notably, the Fisher Court explained that, under Ninth Circuit precedent, strong federal policy favors enforcing forum-selection clauses over anti-waiver provisions in state or federal statutes.[10] If the Ninth Circuit agrees, a Circuit split would exist, ripe for resolution by the U.S. Supreme Court.
Seafarers Pension Plan v. Bradway, 23 F.4th 714 (7th Cir. 2022) ↑
See, e.g., Ocegueda on behalf of Facebook v. Zuckerberg, 526 F. Supp. 3d 637 (N.D. Cal. 2021); Lee v. Fisher, No. 20-cv-06163-SK, 2021 WL 1659842 (N.D. Cal. Apr. 27, 2021), appeal filed, No. 21-15923 (May 27, 2021). ↑
Staffing trends look a bit different for law firms and legal departments in 2022, as the tumult of the past two years settles into more of a business-as-usual mode. It’s a new brand of “usual” for sure—one in which remote and hybrid work models are the norm, and attorneys have made their expectations of better work-life balance clear. As leaders navigate talent wars and heavy workloads (often with limited budgets), more agile staffing solutions are complementing permanent hiring. Alternative legal service providers (ALSPs) are playing a central role in connecting these leaders to contract talent to help round out their teams, bolster productivity, and keep costs in line.
The growing need for specialized lawyers. The circumstances of the past two years—an unprecedented surge in adoption of digital communication tools and automated workflows, changes in workplace/HR policies, commercial contract disputes, etc.—have brought new issues to the fore. Attorneys specializing in data privacy, contract law, M&A, regulatory compliance, employment law, digital technologies, real estate, finance, and other areas of expertise are in demand. In fact, there are layers within many of these areas that require even greater specialization.
Fortunately, supply is keeping up with demand: As more lawyers left their permanent positions to join the contract talent pool in 2020 and 2021, ALSPs have been able to focus their recruitment efforts more tightly to pinpoint ideal candidates. Due to the exceptional value these candidates bring to legal teams, matches often begin as temporary assignments but then grow into lengthier stints or even permanent positions. A corporation that frequently launches new products, for example, isn’t likely to let go of a brilliant regulatory attorney regardless of how, and under what type of arrangement, that attorney came to them.
Renewed focus on how associates’ time is being spent. As legal leaders take a fresh look at how efficiently their operations are running, they are scrutinizing who is doing the work. They understand that paying an associate to carry out routine tasks that could be delegated to a contract attorney with no compromise to quality is a waste of both dollars and the associate’s time. By strategically assigning work to contract attorneys, their organizations are becoming more productive for less money.
For years, law firms and corporations have leveraged this formula for managed document review, due diligence, and other routine tasks. Today, they’re bringing in more outside help to work on NDAs, MSAs, SOWs, digital agreements, licensing agreements, and other contracts. In addition, a growing number of law firms have begun turning to their ALSPs for junior-level contract attorneys they can train to fulfill a particular client’s needs. They can then bill these lawyers out to that client at a much more reasonable rate than they could an on-staff associate.
Increasing reliance on ALSPs. Close to four out of five U.S. law firms (79%) and nearly three out of four U.S. corporations (71%) used an ALSP in 2020, says the Alternative Legal Service Providers 2021 report. The report findings indicate that working with ALSPs has grown to become a mainstream—rather than alternative—staffing strategy, according to Thomson Reuters, which published the report in partnership with The Center on Ethics and the Legal Profession at Georgetown Law and the Saïd Business School at the University of Oxford.
What’s more, law firms and corporations that may have used temporary staffing solutions sparingly in the past, or that tried them for the first time during the pandemic, are now turning to them repeatedly. They’ve discovered that meshing the talents of their internal team with contract attorneys can help them improve their processes and workflows, lower costs, and achieve consistently outstanding results. As these organizations move forward, their perception of contract staffing will continue to evolve as they discover more varied opportunities to put it to use.
One of those opportunities is filling the void left when an attorney goes on leave. Increasingly, law firms and corporations are planning for these contract staffing needs several months in advance. Perhaps this is because so many legal teams were abruptly caught short-handed at moments during the past two years, and they never want to be in that situation again—or it may simply reflect growing confidence in temporary staffing. Leaders are also more likely to recognize that they shouldn’t rely on old protocols of divvying up work among peers when an attorney is out. We’ve all seen the fallout from attorney burnout, and no one wants to further fuel that fire.
Happier, less stressed talent. Speaking of attorney burnout, 2022 is seeing a new cohort of contract lawyers who are definitely not suffering from that particular affliction. These highly qualified pros are raring to go, as they have chosen to infuse their careers with balance while continuing to make a good living. Think about it: If a contractor is making $125 an hour, and they’re working 2,000 hours a year (40 hours a week x 50 weeks), that’s a run rate of $250,000—not a bad income, particularly when it comes with flexible terms. (They can often achieve that steady influx of work by working through an ALSP, which may also offer benefits and other perks.)
Even if they are making less than they were before, many contract attorneys are willing to make the trade-off: less money for more time to travel, write a book, start a business, or pursue other interests. And just like law firms and corporate counsel, many contractors are seeking “try before you buy” relationships that enable them to work with different teams to see where they might find an ideal fit for a permanent position.
The power of relationships. An important lesson many legal organizations learned in the chaotic environment of 2020–2021 was that incorporating contract attorneys into an overall staffing strategy requires an engaged staffing partner. Identifying and hiring talent to fill a particular need should never be a one-off transaction, but rather part of an ongoing strategy to have a strong, collaborative team in place. In 2022, these organizations are looking to solidify their relationships with their ALSPs to achieve long-term staffing success.
Good ALSPs are doing their part by getting to know their clients’ people, culture, and organizational structure well, so that they recognize a good fit when they see it, regardless of whether it’s to fill a particular role at a particular time or in anticipation of future needs. When a great résumé comes across their desk, they should know exactly where that candidate belongs and reach out proactively to let their client know about that talent before anyone else has a chance to swoop them up. This type of close relationship is essential to staffing success.
Overall, the outlook for legal staffing through 2022 and beyond is positive. While there are still issues to navigate—heavy workloads, attorney burnout, talent wars, and the prioritization of work-life balance—agile, cost-effective solutions are at hand. Corporate legal departments and law firms that strategically dovetail in-house and contract talent will be poised to win the day.
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