Seller Loses Earnout Suit – No Strategic Buyer Bad Faith

Introduction

The Seller got past a motion for summary judgment in its gross profits earnout lawsuit against its strategic buyer. See http://www.mk-law.com/wpblog/court-gives-pharmacy-seller-chance-to-collect-earnout/ for my earlier blog about the summary judgment motion.

But, although the seller won the battle, it ultimately lost the war at trial.

The deal

The seller provided pharmaceutical products, supplies, and consultation services to long-term care facilities in New Mexico. The buyer provides nationwide pharmacy services for skilled nursing facilities, long-term care facilities, assisted living facilities, hospitals, and other institutional care settings.

In 2013 the buyer and seller entered into an asset purchase agreement that contained an earnout. The earnout was based upon the gross profits of the business during the period between the first and 2nd anniversary of the closing.

The earnout would be $1.25 million if the gross profits from the customers of the business that stayed with the buyer through the 2nd anniversary of the closing was at least $2.2 million. The earnout would be reduced according to a formula if such gross profits were between $2.2 million and $1.87 million. No earnout would be earned if gross profits were less than $1.87 million.

The lawsuit

At the end of the 2nd anniversary of the closing the buyer told the seller that the business had missed the minimum gross profits target by about $600K; meaning that there was no earnout. The seller sued the buyer and the lawsuit ended up in a New Mexico federal district court.

The seller accused the buyer of sabotaging the business’ customer accounts, causing customers to terminate their contracts with the buyer before the two-year anniversary; and thus, depriving the seller of the earnout. The seller said that the buyer violated an implied duty of good faith and fair dealing under applicable Delaware law by managing the accounts it purchased from the seller so poorly that clients terminated their accounts and reduced the seller’s chances of earning the deferred payment.

The court was not convinced that it needed to imply a buyer covenant to use good faith in servicing the seller customers in order to give the seller an opportunity to achieve the earnout. But even if the court implied a buyer covenant to do so, the court found no bad faith on the buyer’s part to support a finding of a breach of such an implied covenant:

“The evidence does not show that … (the buyer’s) … response to customer complaints and issues, though it was often slow and unsuccessful, was a willful rendering of imperfect performance or otherwise lacked reasonable diligence. …

Though the Court is sympathetic to … (the seller’s) … frustration at the issues with … (the buyer’s) … service and its careless attitude in preparing the Deferred Payment Statement, the Court finds that… (the buyer’s) … service and accounting issues, as laid out at trial, do not rise to the level of arbitrary or unreasonable conduct. …

Thus, … (the seller) … has not met his burden to show, by a preponderance of the evidence, that … (the buyer) … acted in bad faith to deprive him of the opportunity to earn a deferred payment. …”

This case is referred to Huntingford v. Pharmacy Corporation Of AmericaNo. 1:17-cv-1210-RB-LF, United States District Court, D. New Mexico, (June 14, 2019)

Comment

An earnout based upon revenue or gross profit is less difficult to game by the buyer since it is higher up the income statement. Nevertheless, it is still risky for the seller because it is hard to control the buyer’s post-closing behavior through language in an APA, that will force a large nationwide strategic buyer to run the seller’s business after the closing in a manner which will keep the seller’s customers and the customer’s revenues flowing through the earnout period.

Nevertheless, the New Mexico federal court felt that the seller could have improved its chances with additional APA language: “The APA is silent, however, as to the quality or level of service … (the buyer) … would be required to provide the accounts it assumed. … Still, the Court finds it likely that the Deferred Payment Clause could have been drafted to address concerns regarding the level of service … (the buyer) … would provide.”

Maybe so; but with 20/20 hindsight the seller would have done better to ditch the $1.25 million earnout in exchange for a smaller additional amount of purchase price at closing.

By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291

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